Surfing around in the personal finance blogging and podcast world, there is no shortage of advice. Mostly good advice and some not so good advice. Oftentimes, advice that may be appropriate for some or even most investors would be completely inappropriate for others due to different risk aversion attitudes, investment horizons, and so on.
Occasionally, however, I come across examples of truly and irredeemably bad advice. Recommendations that are suboptimal under any and all circumstances I can think of, irrespective of the preferences and parameters of the individual. What’s worse, the financial experts spreading this nonsense do so not because of ignorance or incompetence. Rather, they are fully aware of the suboptimality and against better knowledge spread something that’s less than ideal. And the rationale? It may not be good advice but it’s feel-good advice. Let’s take a look at the two examples of feel-good advice I recently came across:
- The debt snowball: While paying down multiple credit cards, start with a card that has the lowest balance, even if that’s not the highest interest debt. Achieving a “win” of paying off one debt in full is more important than paying down all debts as fast as possible.
- Keeping an emergency fund in a money market account while still having credit card debt: Apparently, cash sitting around in a money-market account, earnings essentially zero interest is more important than tackling high-interest credit card debt.
In both cases, the rationale is that it makes you feel good. The “easy win” of completely paying down one debt or the sense of accomplishment of a having a $1,000 cash cushion certainly feels good. Of course, those two measures probably make you feel better than the status quo, i.e., not tackling your debt at all or not having any savings at all. But wouldn’t the average person feel even better if they knew a faster way to get out of debt? Does anyone else find this troublesome? Do the financial gurus view their readers and listeners as a bunch of feeble financial fruitcakes? Is this some sort of personal finance edition of “You Can’t Handle The Truth” with Jack Nicholson / Colonel Jessup?
Even if our financial gurus believe that we are all so dumb, why don’t they educate us? It is a mathematical certainty that if you have multiple debts then the most efficient way is to use the debt avalanche method, i.e., first repay your debt with the highest interest rate. What about the mathematically inclined people who actually had the right intuition and wanted to use the debt avalanche method? What if they now follow the so-called expert advice and use the snowball method instead after listening to the financial experts? I hope I’m not the only one troubled by that!
But, but, but, … what about the Harvard Study?
I’m glad you asked. The snowball fans now claim that they have the definitive proof of the superiority of their strategy: A study featured in the Harvard Business Review claims that there is empirical evidence that the snowball method is more effective.
Let me start by asserting that whether you’re from Haahvaahd, Haahvaahd Square, or even Haahvaahd Qubed: Your experiment will not invalidate simple arithmetic that shows that the debt avalanche method is more effective.
The only quantifiable result in the study is that people who concentrate their effort of paying down one single debt appeared more focused, motivated and faster in their debt reduction effort than folks who disperse their repayment effort. They found this fact both in a sample of actual customers with credit card debt who tracked their transactions at HelloWallet as well as in a lab experiment (Experiment 1). If I may quote:
“We found that consumers who concentrated their repayments on one of their several accounts paid down more of their card debt than those who dispersed their repayments equally across multiple accounts.”
That’s a really cool and interesting result! But both the snowball and avalanche method concentrate their debt-reduction effort. One concentrates on the lowest balance debt and the other on the highest interest debt. So, the higher motivation for working and paying down debt would apply to both. How this proves that the snowball method beats the avalanche method is a mystery to me.
In Experiment 2, the researchers then go completely esoteric and try to measure the “perception” of the debt reduction progress:
“[P]articipants who had been assigned to a more concentrated strategy […] did indeed perceive greater progress toward their goal of getting out of debt”
Well, if someone has, say, $2934.58 in credit card debt and his or her perception of this debt differs from $2934.58, then maybe credit card debt is not the most serious problem in this person’s life. But maybe I’m just too analytical and too much of a quantitative geek to appreciate the need of introducing some mumbo-jumbo perception measure for something that can be measured easily and precisely to the second decimal. But even if you go that route, again (!) the perception of more progress in paying down debt applies to both the snowball and the avalanche method. This is still no evidence of the snowball beating the Avalanche method!
In experiment 3, though, they claim victory for the snowball method:
“[I]t is not the size of the repayment or how little is left on a card after a payment that has the biggest impact on people’s perception of progress; rather it’s what portion of the balance they succeed in paying off.”
Well, this sounds like that pesky perception measure again. In the lab experiments, there isn’t even a mention of debts with different interest rates. Why would people who use the avalanche method and actually pay down their debt faster then perceive their progress as slower than with the snowball method? This doesn’t make any sense!
Even worse than the snowball advice: Having an emergency fund while still carrying credit card debt
If you thought that the insanity of the feel-good advice above is hard to top, you are so wrong. The inefficiency in the snowball method emerges from the interest rate spread between the smallest loan and the highest interest loan. Probably only a few percentage points in most cases. Sometimes the smallest balance may even have the highest interest rate, so there is no harm at all.
But in feel-good financial advice #2, let’s increase the stakes, i.e., accelerate the pace at which you’ll fall behind with sub-optimal, feel-good advice:
Keeping an emergency fund while still carrying credit card debt.
The number one source for this insanely bad advice: Dave Ramsey recommends saving $1,000 in an emergency fund even before paying off credit card debt. Now we are losing money to the tune of the spread between the credit card interest rate and the (after-tax) rate of return in the money market account where we keep the $1,000 emergency fund. This could easily be in the double-digit percentage, say, 16% credit card rate and 1% after-tax return in the money market account.
Let’s still look at the following numerical example. Imagine a person has $2,000 in credit card debt currently charging 16% plus a $1,000 emergency fund. What is the incremental advantage of not following Dave Ramsey’s advice? What happens when we pay down the credit card balance with the $1,000 savings? The numbers are in the table below. Notice that the $12.50 advantage is independent of whether an emergency actually occurs or not. If we don’t have an emergency we save the credit card interest on the $1,000. And if we do have an emergency after a month then, well, we charge it to the credit card and still have a lower balance than Dave Ramsey. It’s a win-win situation!
You are now leaving cash on the table, all for the purpose of feeling good. True, it’s only $12.50 per month. But remember, the $12.50 per month is meaningful enough for someone who wants to get out of $2,000 of debt. If you want to spend $12.50 per month to make you feel better, why not use that money to pay down debt faster?
On this blog, we strive to give good advice. Sometimes good advice may not be consistent with what feels right or feels good, whether it’s due to behavioral biases or computational limitations. Sometimes I catch myself “agreeing” with people who propose suboptimal advice, thinking “well, if makes them sleep better at night…” I shouldn’t! I owe it to my readers to point out flaws in the feel-good strategies like the debt snowball. If people continue to feel good about bad advice, then we in the blogging community haven’t done a good enough job to explain some of the shortcomings of widely cited suboptimal strategies. After all, there is no better feeling than getting out of debt faster and building wealth faster!