Wednesday, September 5, 2012

A new course in financial literacy

I was asked to teach a quick course to our new batch of Global MBA (GMBA) students. The idea was to refresh their math and economics skills, and thus it was named “Jumpstart.” I resisted doing it with all my strength. The course was scheduled for the first week of August and I had my sandcastle-building supplies together and was ready to head to the Italian beaches. But the faculty dean knows my weaknesses and told me I could use the course to teach financial literacy. So, I put aside my swim suit and sun block and started designing and preparing for this short course (in case you were wondering why I have not been writing my blog. . . ).

As you can imagine, the challenge was what to teach to students who come from all over the world and who have different backgrounds, in particular now that our dean is set to admit only students who want to change the world. (I am not kidding, and he says this when he meets the students; it is impossible not to like him.) But I discovered that this is an ideal group to teach financial literacy to; after all, this is a topic based on rigorous and universal concepts (interest compounding is the same in the US as it is in China), and I do not have to hold back the math.

The course was structured in four classes of three hours each. In case you think this allows for little time, let me assure you that there is a lot you can teach in three hours; the difficult part was choosing what is most important. I structured the course to cover the following topics: 1) understanding interest compounding and the time value of money; 2) understanding probabilities and risk; 3) essential macro concepts; 4) applications to personal finance and macro problems.

I have had many discussions at conferences with people who assert that one cannot teach (and people cannot learn) interest compounding. I cannot disagree more. This is a fundamental concept and is at the basis of every financial decision. If there was one thing, and one thing only, that I could teach in a course, this is what I would choose. It is only by appreciating the power of interest compounding that one learns the importance of starting to save early in life or of being careful when borrowing, given that interest rates charged on borrowing are often much higher than interest rates earned on assets. Most importantly, because our financial resources are spread over time, we need to be able to understand that a dollar tomorrow is worth less than a dollar today, and how much less depends on whether the interest rate is high or low. We cannot sum values due at different points in time (for example, our earnings each year); we need to discount future values to the present, and we do so simply by applying the formula of interest compounding. Because financial decisions are essentially about shifting resources over time, we need to have a basic understanding of interest compounding.

As an aside, I would like to remind those who think that people cannot understand or learn interest compounding that we let students take up large loans to pay for their education and that we have put people in charge of saving for their retirement. It is scary to think that people can and do make these sorts of decisions without understanding interest compounding; if we do not teach them, we all are going to pay for it. I told this to the GMBA students, too, since they are charged with the small task of changing the world. Giving people an understanding of this concept seems to bring results. I will not know what my students end up doing with this knowledge yet, but according to a recent paper describing a field experiment in China, teaching people living in rural areas about interest compounding increased their pension contributions by 40% . How about that! (The link to the paper is at the end of this post).

Teaching the concept of risk was the most difficult part of the course. In the many surveys I have conducted to assess financial literacy across countries, questions covering the concept of risk always get the smallest percentage of correct answers. This is why I covered this topic in the second rather than the first class and why I provided many examples—some of which involved dealing with pirates, just to remind students that finance has a wide range of applications. Like interest compounding, risk is an essential concept; most financial decisions have to do with the future, but the future is uncertain. Thus, we need to reason in probabilistic ways. For example my income next year may be, say, $50,000, but I also face a probability (about 8%) that I will be unemployed; and, while the interest rate on my bond is set at 5% for next year, there is also a chance that the issuer will default (yep, and these issuers can be governments…). It is critically important not only to grasp the concept of risk but also to know how to deal with it. While we all face risk, there are ways we can reduce it and minimize its impact. In fact, an important component of personal finance is not only to grow assets (using the power of interest compounding) but also to protect those assets (using the concept of risk diversification). One of the applications the students most enjoyed were the lotteries; they may be fun, but if you plan to become rich by winning the lottery, you are in dire need of taking this course!

And speaking of the future, one thing that changes over time is prices, for example, the prices of the goods we normally buy (this is what the Consumer Price Index, or CPI, measures). This is a bummer, because it means that if our money does not grow, our dollar today will buy less tomorrow. In other words, to make financial decisions we need to understand inflation and what inflation does to our purchasing power. This is why in the third lecture I turned to macroeconomics, and we studied inflation and the difference between nominal and real interest rates. It was also a lecture designed to teach the critical role of central banks and why we need these institutions in the economy. I hope my students have a better understanding now of the Herculean job that Chairman Bernanke and President Draghi have at the helms of the US Federal Reserve and the European Central Bank, respectively. Given that, by this time, students knew about interest compounding, we also covered economic growth (it is the same formula!) and calculated when China’s economy is expected to surpass that of the US. Write me a note if you, too, want to know this.

In the final class, we covered many applications that were also sprinkled through the other lectures. Armed with the knowledge of the fundamental concepts we had covered, there were almost no decisions we could not attack! For example, we calculated the return on the investment in an MBA degree and whether (and when) it makes sense to leave your job, pack your suitcases, and head to school again. We looked at methods of payment and when it is advantageous to lease versus pay cash and the implicit interest rates in a stream of payments required, for example, when paying back a loan. We calculated the gain from exploiting employers’ retirement saving matches and the return on contributions to Social Security under different longevity scenarios. Most importantly, we calculated what it takes to become a millionaire and discovered it is not overly complicated (again, you need to take this course if you want to know).

There were several rewards in teaching this course. First, I could finally pack my bags and head to the beach in mid August, when the sun in Italy was still burning. Second, I felt like I was making a difference—as my dean would say— if not in people’s lives, at least in their financial decisions. One student sent me a thank you note at the end of the course that was very touching and inspiring. So inspiring, in fact, that I plan to keep it in my desk drawer and read it whenever I return from conferences that discuss the futility of teaching interest compounding and the ineffectiveness of financial literacy.

For more information, see Changcheng Song (2012), "Financial illiteracy and pension contributions: A field experiment on compound interest in China."


Anonymous said...

Your posts are always inspiring. I am glad to hear that your students will be changing the world. Someone needs to! As for compounding, even I, a person with a marketing degree, understands that and how important it is in saving or borrowing. Glad you keep spreading the word.

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