A Top Economist's Financial Rules to Live By

Kiplinger's spoke with Alan Krueger, a professor of economics and public affairs at Princeton University and author of Explorations in Economics, about common money misthaps. Here's an excerpt from our interview:

What are the most common financial mistakes people make?

There are two in particular. The first is the tendency to choose smaller rewards in the near term at the expense of a larger long-term goal. That’s partly why people save too little for the future. It’s described in my book as being impatient, not forward-looking enough. Second, people, especially men, tend to be overconfident. This could lead to not diversifying investments enough or trading too much.

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How can people avoid those mistakes?

It’s hard to teach people to be rational. So it’s important to teach habits. Instead of going through the steps of decision-making, people can adopt habits that automatically work for them. Or we can set defaults so that, without making a conscious choice, people do things in their best interest. Examples of defaults include automatically enrolling employees in 401(k) savings plans, or putting money in a target-date fund, in which the portfolio mix changes appropriately as people age.

Are there rules of thumb that can help?

Yes, that’s what I mean by habits. We’re asking a lot, teaching financial decision-making to 17-year-olds and then expecting them to remember and apply what they learned 15 to 20 years later. By contrast, you don’t have to think about rules of thumb. Don’t spend more than one-third of your budget on housing. Keep separate accounts for business and personal expenses. Buy insurance for costly things, such as health care or a car, but not for small risks than can be covered out of pocket. Put money aside for a rainy day. You don’t need to know the formula for compound interest to know that if you start early, your savings grow more quickly.

What’s the primary takeaway from your textbook?

That economics is a framework for making good decisions.

What resonates most with high school students?

They like the examples. There’s the truly inspiring story of Oseola McCarty, a cleaning woman who worked hard every day of her life, lived within her means and put aside enough money to donate $150,000 to the University of Southern Mississippi so that other people wouldn’t have to work as hard as she did. By contrast, William “Bud” Post won $16 million in the Pennsylvania lottery and died penniless. It just shows you that the decisions people make have enormous consequences.