On the Usefulness of Counter-Intuitive Financial Advice
One of my favorite insights made by Claude Shannon, the father of information theory, was that the English language was redundant. To be precise, Shannon estimated that 50-75% of the English language could be removed without losing any information.
What do I mean by this? Imagine someone sent you a message asking you where you left your house keys. You might respond, “On the right side of the television.” However, this message contains lots of redundancy. You could’ve said, “On the right side of the tv,” and gotten the same message across with 8 fewer letters. If you wanted to eliminate even more redundancy, you could say, “right side of tv” and remove three words while still disclosing the location of your house keys.
James Gleick provides a more extreme example of English’s redundancy in The Information: A History, a Theory, a Flood when discussing a famous New York City Subway ad from the 1970s (also a poem by James Merrill):
if u cn rd ths
u cn gt a gd jb w hi pa!
As you can see, you were probably able to understand the above message without the need for all of the additional letters. As Gleick states, “Every natural language has redundancy built in; this is why people can understand text riddled with errors and why they can understand conversation in a noisy room.” In this way, natural language is not efficient, but effective.
When it comes to personal finance there are plenty of cases where the most effective solution isn’t necessarily the most efficient. One of my favorite examples is Dave Ramsey’s debt snowball method for paying off debt. Dave’s method recommends that borrowers pay off their debts by balance (smallest to largest) rather than interest rate (highest to lowest).
Dave argues that by attacking the smallest balance debt first, you get a psychological win under your belt that will motivate you to pay off your other debt. Mathematically, this is not the most efficient way to pay off debt, since you would save more money by paying off your highest interest debt first. However, the debt snowball has been effective in inspiring thousands of people to become debt-free. As Dave correctly states, “It’s all about behavior modification, not math.”
This same kind of argument can be made around savings apps that charge “high fees” to get users to save/invest more money. For example, Acorns is a savings app that rounds up users’ purchases and invests the difference. So if you bought a coffee for $2.75, Acorns would charge you $3 and invest the additional $0.25.
Meb Faber and others have been critical of Acorns because of the $1 monthly fee they charge though the average account size is only $230. On a percentage basis the fee Acorns charges is high (>5%), but on an absolute basis it is low ($12 annually), especially when you consider that the median Acorns user has an income of $50,000-$60,000.
My counter to Meb’s argument is that Acorns may be the most effective way to get some people to save and invest. Yes, paying 5% seems high, but that fee is applied to a low balance. The $12 that Acorns charges can easily pay for itself if it inspires someone to improve their financial life.
Though it seems farfetched, paying a fee can be an effective way for someone to change their behavior. In Portfolios of the Poor: How the World’s Poor Live on $2 a Day, the authors demonstrate this when they state, “If you’re poor, borrowing can be the quickest way to save.” When I first read this I thought it was ridiculous. How could debt be used to help increase savings?
The authors then went on to explain that some households need debt as a way of forcing themselves to save. The debt acts as a commitment device. For example, a man based in Delhi named Satish said he borrowed because “the pressure of interest charges encouraged him to repay quicker.” Once again, behavior trumps math.
The more you look, the more you will find examples where efficiency does not equate with effectiveness. I have written about this previously when I discussed success by exhaustion, or the concept of using brute force to accomplish your goals. One of my favorite examples of this comes from Scott Galloway:
The majority of (actual) wars have not been won with strategy, bravery, training, or superior equipment, but brute force. At the end of WWII, the Allies had 38 gallons of gasoline for every one the Germans did.
While I am all for working smart, sometimes working hard is the best option available. So before you critique a financial strategy for being inefficient, ask yourself: is it effective?
The Most Effective Financial Advice
Many of the posts on Of Dollars And Data have revolved around being smart with your money.
However, most of your financial success is going to come down to one simple metric: your savings rate. It might seem absurd, but it’s true. If you can save enough money, none of the other financial advice on this blog will matter. Why? Because with a high enough savings rate, you will never need to worry about your asset returns.
Of course, saving lots of money is easier said than done. For the rest of us that must rely on decades of compounded growth to reach our financial goals, my most effective financial advice hasn’t changed in over two years: Just. Keep. Buying.
If you are interested in learning more about the tradeoffs between efficiency and effectiveness when it comes to how humans use information, check out The Information by James Gleick. Thank you for reading!
This is post 126. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data