Friday, April 5, 2013

Financial literacy: is it rocket science?

An attendee at a recent conference stated that financial literacy is not “rocket science.” I almost fell off my chair. There was a group of speakers presenting at that moment, and I could not comment or ask for clarification right away. While sitting silently on the edge of my chair I realized that, unfortunately, this is how financial literacy is often perceived, in particular among practitioners. Some people think that financial literacy is a set of good practices that, if you try a few times or long enough, you eventually  master, like basic woodworking or cooking. Others think that financial literacy is a bunch of rules—such as “live within your means”—that should guide behavior.

Let me just say how strongly I disagree with these views. Financial literacy is based on mathematics, finance, and economic principles. It is grounded in rigorous concepts, such as the power of interest compounding, which is a fundamental concept at the basis of financial decision-making. Rules allow people to make decisions only in a very narrow set of circumstances, for example, when a situation repeats itself, which is rare in the world of finance. Moreover, rules fail to recognize that people are very different; they have different needs and face different circumstances.

In my view, we have to equip people with the knowledge and skills necessary to make decisions. Let me be specific and provide an example of what I mean.  Here is a situation we can face (it is taken from my Financial Decision Making course):
A consumer is considering leasing a car that retails for $30,000.  Under the lease agreement, she can lease the car for two years at an interest rate of 6% with a capital cost reduction (down payment) of $2,000.  The residual value under the lease is 56% of the car’s retail value, or $16,800.  The lease requires an additional $100 in fees at signing and a security deposit of $600.  The sales tax is 5%.  Alternatively, the consumer could finance the car for two years using a loan.  The auto loan has an APR of 6% and requires a 10% down payment. No fees due at signing. After two years, the car’s trade-in value is expected to be, as for the lease, $16,800.  The consumer can earn an interest rate of 4% on her savings. What should the consumer do: lease or borrow?

The exercise looks cumbersome and headache inducing. But there is no shortcut or good pain killer to help determine which is the best decision. Even if one has bought a car before, each new contract can require a new decision. Each of us can be offered this contract and with many variations, because we get different offers and different cars. There are no simple rules that apply, such as “it is never a good idea to lease a car.” One has to do the calculations to figure out what is best, there is no other way to make that determination (apart, of course, from being willing to lose money). And as any of my students can tell you, this problem is rather simple to solve once you draw up a timeline, consider when payments have to be made, take the present discounted values of those payments, and compare them. Voilà! The answer is that the consumer should lease, and that leasing is about $700 cheaper than borrowing.

As an aside, I find the rule “live within your means” a really hard one; the calculations there are very complex. What are my “means”? Clearly, not my current income and wealth.  My financial horizon is not just one year; If I am taking two years off from work to pursue a master’s degree, my income will be very low today (in effect zero), but it does not mean I should not eat.  As the Nobel Prize economists Franco Modigliani and Milton Friedman stated, the “means” to consider are the resources over a lifetime. But these calculations are rather complicated, as one has to make projections about future income. So, thanks for the rule, it seems sensible, but without making a calculation, it does not tell me how I can live.

Not all calculations are that difficult.  But they are very valuable. For example, it would be good for young people to calculate how much it costs per month to pay off their student loans, say, in 10 years. This knowledge would help with other financial decision involving monthly cash flow as well, such as buying a house or starting a business. And we cannot rely much on trial and error or learning from experience, as most of us do not buy cars very often, go to college five times, or repeatedly retire.

I really hope that this is what will be taught in schools and that students will build a rigorous base of knowledge that will equip them to make sound financial decisions. In my view financial literacy is as much a rocket science as it can be. Seeing it another way, without financial literacy, the one trillion dollars in current student debt will be a rocket that will crash squarely on our heads!


Anonymous said...

I think that both of you are right. More often than not, good personal finance decisions involve choosing generics rather than name brand, shopping at Costco rather than whole foods, avoiding credit card interest like the plague, eat out infrequently, avoid excessive recurring expenses like cell phone bills, cable tv, etc.

You bring up a buy vs lease example with a car. I didn't do the math, because I'm lazy; However, I know that the difference between leasing vs buying is so trivially small relative to the recurring day-to-day "not-rocket-science" decisions.

Another example is active vs passive investing. If I'm dumb and pay 1%/year in mutual fund fees rather than 0.05% a year at Vanguard, this is costly. However, it's much more costly if I'm an idiot on a daily basis.

xignite said...

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xignite said...

Thanks for providing such useful information. I really appreciate your professional approach. I would like to thank you for the efforts you made in writing this post.

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Tonia said...

This is cool!