Laurence Kotlikoff - Money Magic: An Economist’s Secrets to More Money, Less Risk, and a Better Life

When I started college, I hoped to become a doctor. But a frog derailed my plans. The frog and I came eye to eye in a biology lab as I injected it with death serum, sliced open its chest, checked its pulse, declared it dead, and proceeded to rub its tiny heart back to life. My instructor walked over and said, Excellent. Now do it again and record the results. For the next two hours, it was kill-resurrect-record, over and over again. By the end of the lab, I was majoring in economics.

I got hooked on economics. There was no torture of slimy amphibians. Plus, I liked the math, the curves, the statistics, the theory. But what really grabbed me was economics potential to help people.

In grad school, I focused on public finance, particularly how tax and benefit policies affect the macro (overall) economy. This was the mid-1970s, and economists were just starting to use apartment-sized machines called computers. Wed type up our code on seven-by-three-inch punch cards in an ancient language called FORTRAN, run them through a noisy card reader, and wait hours for yard-wide printouts. Mostly, the program would fail because of a typo on card 7,239 of a 10,000-card deck. But if the program ran and the results made sense, wed write up our earth-shattering findings and pray someone would read them.

Studying the macro economy requires understanding the micro economythe financial actions and reactions of individual companies and households. For households, this includes coding personal financial behavior. Hence, public finance led me to personal finance and the work of a long list of prominent economists. The list starts in the 1920s with Yale economist Irving Fisher.

Fisher was, hands down, the top economist of his day, and his most important achievement was a simple but powerful mathematical description of optimal saving behavior. Fishers model looked for the saving sweet spot that keeps us from starving when young and splurging when old (or doing the opposite). Finding that spot, he argued, entails saving precisely whats needed to ensure a smooth living standard over time. Thus was born the principle of life-cycle consumption smoothing.

Fisher is the father of economics-based financial planning. But he left lots of issues unexplored, including how to manage ones investments. The answer is certainly not to put all your eggs in one basket, especially a basket as fickle as the stock market. Yet this is precisely what Fisher did. Being the smartest economist on the planet, Fisher assumed he knew how the market would behave. Except he didnt. On the eve of the Crash of 1929, Fisher publicly pronounced that stock prices have reached what looks like a permanently high plateau I expect to see the stock market a good deal higher within a few months.

As the market dropped 86 percent by 1933, Fisher went from rich to poor to bankrupt. Had Yale not interceded, Fisher would have ended up living on the street. He died in 1947, disgraced in the publics eye by his infamous prognostication yet still revered by economists for his amazing theoretical insights. Over the next two decades, Milton Friedman, Franco Modigliani, Paul Samuelson, Robert C. Merton, and Peter Diamondall future economics Nobel laureatesand a host of other prominent economists began extending Fishers life-cycle model.

Hence, by the time I reached grad school, economists had formed a clear theory of how people should save, insure, and invest. They also understood why no onenot even an Irving Fishercould predict the stock market. Of course, developing a theory and expecting people to adhere to its tenets are two different things. Were real-world households doing as economic theory prescribed? Were they saving enough? Were they buying enough insurance? Were they choosing the right careers? Were they taking on too much debt? Were they investing appropriately? Were they making the right Social Security and tax moves?

These and similar questions took up residence in my brain and those of other econ eggheads. Many of us started to compare actual personal financial behavior, as reported in nationwide household surveys, with theoretically appropriate behavior. Within two decades, the picture was both clear and ugly. Essentially everyone was making big financial mistakes: saving far too little or far too much, buying the wrong amount of life insurance, borrowing irresponsibly, leaving great sums of lifetime Social Security benefits on the table, paying significantly more taxes than required, becoming house poor. The list goes on.

The economics profession took this news poorly. What? People arent adhering to our beautiful theory? How dare they? They must be financially sick. They lack self-control! They are myopic, financially illiterate, or both! Peoples greedy present selves were ripping off defenseless future selves by overspending and undersaving. Overnight, a new field of economics arose, behavioral finance, devoted to studying the precise pathologies underlying individuals awful financial decisions.

Economists dont always agree. Indeed, they dont always agree with themselves. President Truman said he needed a one-handed economist to stop hearing On the other hand. Im a two-handed economist, but my take on behavioral finance is unequivocal. I strongly dispute the premise that people screw up their finances because they are badly behaved, financially lost, shortsighted, or mentally ill. Even the most responsible, prudent, financially well-educated, and psychologically balanced people make major mistakes. The reason is simple: the financial problems we face are unbelievably complexfar beyond the capacity of our brains to solve without some clear direction.

Why do I think this? Three reasons.

The first reason is self-reflection. I recognize that even my own economically pretty well-trained brain isnt remotely up to the task. If, for example, you tell me all about your personal finances and ask me the annual amount you can permanently spend this year and every year through the rest of your lifein other words, if you ask me to smooth your consumption off the top of my head, with no paper and pencilmy answer will surely be off by 30 percent or more.