Friday, December 19, 2008

Financial Advice for the Public

In previous posts, I have argued in favor of professional financial advice. Do not get me wrong, I am not saying that using a financial advisor is the only rational choice. Rather, I want to argue that there need to be alternatives for people who have little financial knowledge and who may currently choose to “do nothing” or to rely on the advice of people who may know as little as they do. But choosing a financial advisor can be a difficult task, so we need to find alternative sources that can provide advice and guidance.

In other fields, such sources exist or have emerged. If you go to the National Cancer Institute’s web site, for example, you get basic information about what cancer is, available treatments, and a link to information about smoking that offers “free help to quit.” I like the smiles of the patients on that web page and the stern yet reassuring looks of the doctors. The U.S. Department of Agriculture has established the “food pyramid” to give guidelines about healthy eating. These are very general guidelines; nevertheless it is good to know that we should eat vegetables—lots of them. Moreover, some books have become “the bible” on certain topics. I am thinking of What to Expect When You’re Expecting, which almost every first-time mother I know read during her pregnancy.

Now, where do people go when they need financial advice? Which web site should they consider? Which book should they read when they want to start saving or investing or managing their debt? Believe me, there is a lot of information out there. The problem is that there is too much, and—in my view—a lot of confusion about what source to use. What is worse is that many people would like to dispense financial advice, irrespective of their qualifications.

There is an institution that is well-equipped to provide financial education and improve financial literacy. This institution meets three important requirements: (1) It possesses high qualifications, meaning a knowledge of economics and finance; (2) It is independent of the financial industry and any lobbies; (3) It cares about the well-being of consumers. As you may have guessed already, this institution is the central bank. Central banks in all countries, and the U.S. Federal Reserve in particular, have armies of bright Ph.D. economists who spend much of their time monitoring the state of financial markets. Central banks in most countries are independent institutions whose primary objective is to fight one of the big enemies of saving: inflation. Moreover, they are interested in the smooth functioning of financial markets and have incentives to care about citizens.

The U.S. Federal Reserve is already working on financial education (check their web site:, but my recommendation is that they do more. First, they should take up that role officially and with more fanfare so that people know where to go for financial information. Second, they should provide a lot more resources on line. Their web site should be a “bank” of information. Third, they should offer some recommendations. As broccoli is good for you, so is risk diversification. Finally, on that web page we need a stern-looking Ben Bernanke, a few smiling, happy investors, and a link to a free guide on how to save.

Sunday, December 7, 2008

Financial Advice

In earlier posts, I have discussed financial advice and the fact that most people tend to consult family and friends when making financial decisions. In this post I would like to discuss consulting financial advisors. There is little research on this topic, but it seems to me it is an important area of interest. In a new financial world, where financial instruments are increasingly complicated, professional financial expertise can be very valuable. We may associate this sort of financial advice with setting up trusts, legal counseling, and complex investment strategies that preoccupy only the rich. In fact, financial decisions of the average family or individual have become sufficiently complex that such advice may be not only beneficial but also necessary. More so when, as I have argued repeatedly, there is very low financial literacy. Overall, it is not easy to choose the best mortgage (or even a good mortgage) among so many options. Similarly, it is not easy to know how much to contribute to a pension plan and how to allocate pension assets, not to mention how to best save for children’s education or simply how to deal with debt.

While many would admit that these decisions are difficult, few consider getting professional financial advice. Clearly, cost can be an issue, but it is not obvious that the cost, in most cases, is greater than the benefits. Consider, for example, retirement planning: setting up a plan for how much to save and how to invest retirement wealth may be very beneficial. According to the Retirement Confidence Survey and my own work using many waves of the Health and Retirement Study, many workers do not know how much they need to save for retirement. Even those who claim to have done some calculations are often not able to give the amount they will need at retirement or give figures that seem very rough estimates. This may reflect the fact that workers use rather crude tools to make retirement saving decisions. For example, a quarter of those who report being planners do not use any planning tools at all! However, planning does pay off. Those who report doing calculations of how much they need to save for retirement end up close to retirement with three times the amount of wealth of those who do not plan. And do not think that planning and financial counseling is simply for those who can afford it (i.e., those who have wealth). Counseling can be even more beneficial to those for whom every dollar counts. How families manage their balance sheets is very important, and making good financial decisions may have huge implications on our well-being, as the current crisis seems also to suggest.

Yet, people give little thought to these decisions and few consult financial advisors. Clearly, it may be challenging to find good financial experts who are motivated by incentives that do not work against consumers’ best interests, such as those whose compensation derives from high fees assets. But in my view, one reason we do not generally consult experts is that it is hard to know whether and when we are in financial trouble or can prevent financial trouble. For example, without going through the planning process, there is little to signal to people that they are not saving enough for retirement, particularly when they are many years away from it. We may only realize we have not saved enough when it is too late. It might be interesting to consider an analogy to guidelines regarding health maintenance issues. First, we do not normally self-medicate (or do surgery on ourselves) but we go seek (or should seek) medical advice when we have a problem. Second, even without being in pain, we tend to do check-ups to make sure we are in good shape and we will not have problems in the future. Third, we ask for a second opinion when in doubt. Wouldn’t it be a good idea to do the same for our finances?