Saturday, July 12, 2008

Are You Financially Literate? Do this Simple Test to Find Out

One component of my “financial literacy initiative” is to provide (and share) ideas, suggestions, and tools to people interested in financial literacy. While I have discussed extensively financial literacy in previous blogs, I have not discussed how to measure financial literacy. However, this is a major part of the academic research I do. Together with Olivia Mitchell, I have devised three questions that are pretty successful into classifying respondents into levels of financial knowledge. I report the questions below. I urge all of the readers of this blog to go through these questions. In my view, it is important that we evaluate how much we know and simple tests like this one can serve this purpose (ok, I admit, it is the academic in me speaking…). Moreover, we could use these simple tests to classify respondents into different types and assign them to different groups. For example, new hires could be given a test to assess their financial knowledge; those who display little knowledge could be advised to consult with the HR office or a financial advisor before selecting their pension fund and the allocation of their pension assets. Why make important financial decisions ourselves if we know little or nothing about finance and economics? (And beware of asking your brother in law, chances are he knows much less than you were hoping for, but now there is a way to find out!).

Here are the questions:

1) Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
a) More than $102
b) Exactly $102
c) Less than $102
d) Do not know

2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
a) More than today
b) Exactly the same as today
c) Less than today
d) Do not know

3) Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”
a) True
b) False
c) Do not know

The answers are reported at the very end. To be “financially literate” you need to answer correctly to all three questions. If you are able to answer correctly to two questions only, you are not in bad shape (in particular if you were able to answer correctly to the third question), but you need to improve your financial knowledge. If you answered correctly to one question, you are not in good shape and you need to improve your financial knowledge. If you got all questions wrong, you did not get a passing grade. If your answer was “do not know” to at least two of these questions, you are also not in good shape.

Now, let’s admit it, it is not fun to go through these types of tests and it is even less fun to find out that we do not know the answers to these questions. While this is true, it is also the case that how much we know influences how well we do in our financial choices. So, let’s leave these concerns aside and take the test. Financial literacy pays off! And next time your brother in law advances a suggestions on the stock you should buy in this turbulent market, smile and quickly shift the discussion to the weather (it works very well, at least in New Hampshire where the weather changes even more erratically than the stock market).

Answers

1. a) More than $102

2. c) Less than today

3. b) False

2 comments:

Ric Kellogg said...

Dr. Lusardi,

Thanks for your hard work and insight. I look forward to more. These literacy questions are perfect. In fact, I've been citing the questions you posed in your 2007 study in group retirement savings presentations and financial education discussions since first reading it almost a year ago. It's fascinating, I suppose, what with this social dilemma as widespread as it is that no more are working on understanding the problem and proposing solutions than seem to be. I concur with your previous assertion that one hour investment presentations or one week personal finance classes are never going to reverse this direction in illiteracy. But what then can be done? For years I've been suggesting, to anyone who would listen, that we need a "revolution" in thinking about how the public education system can be a tool for delivering meaningful financial literacy concepts on a full-time basis beginning at young ages. Nevertheless, your commentary is "spot on" the real issues and we will continue to share education so that people may make good choices about their future.
-Ric Kellogg, Merrill Lynch

Harpreet said...

Hi,

I have gone thru ur blog post and found it very interesting. Luckily I could answer all the three correctly.
Keep on posting more .