Finance and the Ski Trails

I have spent the holidays in Italy and, as in much of the United States, the snow was plentiful. It was good to be on the slopes and to enjoy the amazing views from the top of a mountain.

The Italian Alps were crowded with skiers. As some of you know well, beginner skiers are the most dangerous people on the slopes. Many of them do not yet know how to navigate the lifts and the trails, they think they ski much better than they actually do, and they are often in the way of other skiers. But ski resorts are well-organized places. First of all, the trails have been ranked and clearly labeled according to their degrees of difficulty. This information is presented in a very simple way. A set of colors and shapes tells skiers everything they need to know: black diamond (experts only), blue square (intermediate), green circle (beginners). There are no complicated formulas that calculate steepness of the terrain or statistics on the probability of falling down and breaking a leg. It is a simple system, yet very effective; beginner skiers know to stay off of the black diamond trails and experts know that they will encounter unsteady beginner skiers on the green circle trails. Additionally, there are well-established rules that govern skiing. The rules are simple, they are clearly posted, and they are taught in any beginner course. These rules are enforced; there are numerous ski patrols on the slopes in the Alps. I saw them in operation, and I can say they have watchful eyes and are excellent skiers (yes, way better than I am).

Let’s move now from the Alps to the financial markets. There are a lot of beginners out there as well, people who have never bought stocks or even opened a checking account. Do these people know when they are venturing onto black diamond terrain? Even in the Alps, it can be difficult to tell whether a trail will be hard or easy by simply looking at it from the top of the mountain; skiers need the information that is posted at the start of a trail, especially the beginners. The same is true for finance. Financial operations are complex and people often venture into contracts without fully understanding what they are getting into. Just like beginner skiers who venture onto a black diamond slope, people entering into complex financial contracts can be at risk and can hurt themselves financially. In skiing, it is very clear that those who make mistakes on the slopes can hurt not only themselves but also other skiers. In finance this has not always been very clear, but the current crisis has made it evident that mistakes can be paid for not only by those who made them but also by taxpayers.

There is another important feature to highlight, something that I have experienced many times. Everyone wants to be an expert and many people think they are better skiers than they really are. In fact, if you want to keep your relationships intact, never tell your friends and family what you really think of their skiing abilities. This is, of course, problematic because it means they may not learn about their weaknesses and limitations until they hit a tree. Even then, some may think it was the tree’s fault that they crashed. In finance, it is often the same. In all of the surveys I have conducted to measure financial knowledge, I have found that the large majority of respondents display little financial knowledge. Yet, when asked to assess their own level of financial knowledge, most respondents think they have a high level of knowledge, well above the mean. The financial crisis should have sent a strong signal about lack of financial knowledge, but some may still think it is the tree’s fault.

Now that I am off the slopes and back in the office, I have a few recommendations to offer. In my view, we need beginner courses in finance, so that people can learn how to navigate the complex system before they venture out to engage in financial contracts. We need to provide information about contracts, and that information should be as easy to understand as a sign at the start of a ski trail. And we need to find ways to easily assess and to inform people about how much individuals know—and don’t know—about economics and finance.

As for me, I love the Alps, the smell of the fresh air and the snow and the views from the top of the mountains. The descent from the top of the mountain to the bottom is so difficult that it makes me appreciate skiing even more. And I appreciate the warnings as well. They should be repeated as often as possible: Please be careful and go slowly

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: http://www.federalreserve.gov/), 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.

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?

Friends, Family and Finances

In this post, I want to talk about how people become financially literate and from whom they learn about finances. In many of the surveys I have reviewed, including the ones I have designed, people report that they rely on family and friends for financial advice. In focus groups as well, people state that they learn from their family and friends. This is an important finding. I believe that people rely so much on friends and family because they want advice from people they trust and who have their best interests at heart. There are, however, limitations and drawbacks to relying solely on friends and family for financial advice.

One limitation of learning from our friends is that we tend to choose friends who are like us. So, if you are an artist, you are likely to be surrounded by people who know how to draw but do not necessarily know how to invest retirement savings. Furthermore, many financial matters are private. You may assume that your friend John is financially savvy, but you have probably not seen his 401(k) statement, and it is hard to tell from his house or car whether he is good at picking mutual funds. Nevertheless, he may be happy to offer you tons of financial advice.

Like friends, family members, parents in particular, are a popular source of financial advice, and many have argued that financial education does start at home. There are, nevertheless, drawbacks to advice from this source. First, not everybody has parents who are financially literate. Approximately half of the families in the United States do not invest in the stock market (at least when considering investment of private wealth). Thus, for many, it is not possible to learn about the stock market from parents. Second, parents—particularly older ones—lived in a very different economic environment than the one the current generation of working Americans are facing. Most parents of today’s young and middle aged adults had pensions that were defined benefit plans, experienced inflationary periods that decreased the burden of their debt, and hardly invested in the “global economy.” Financial markets have changed substantially from the time this generation of parents bought their homes, got their pensions, and invested their savings.

I do not mean to imply that we cannot learn from family and friends. One valuable lesson can be to avoid the mistakes that those around us have made, such as not preparing adequately for retirement, not having enough insurance, or having too much debt—mistakes that are proven to be all too common among many Americans today. But relying on such advice seems to me often too little and sometimes too late.

In my view, financial education belongs in schools. Finance and economics are sciences and should be taught as such. Moreover, people need to be financially literate before they engage in financial contracts and not after having learned how much financial mistakes can hurt. Finally, having financial education in schools offers a better chance that students whose parents do not work on Wall Street will be able to access financial knowledge.

There is an additional benefit: if everyone learns about finance in school, we can then talk to our friends about art, about history, about something other than our finances. One of the great benefits of obtaining financial savvy and know-how is that we are then able to devote ourselves to what really matters to us, without the distraction of financial worries.

The National Financial Literacy Challenge

From November 3 until November 26, 2008, high school students can participate in the National Financial Literacy Challenge. This online 35-question test measures financial knowledge and serves to document the state of financial literacy among participating high school students. Please help me spread the word about this test and encourage the school in your district to register to participate.

It is important that we measure financial literacy among high school students. These young people soon will or already are confronting financial decisions, such as taking out student loans to pay for college, managing credit cards, and saving or spending income from summer employment and allowances. Are young people well equipped to make these decisions? We do not know, and we need to find out! Several states have mandated financial education in high schools and there is a lot of discussion about whether financial literacy should be integrated into high school curricula. I particularly encourage the schools where financial literacy has been mandated or where courses on financial literacy are offered to participate in this test. All tests are imperfect to some degree, but we need some measurement of how much our students know and how well we are doing at teaching financial literacy.

And there are rewards for participating in this test (can you tell that economists devised it?). Students scoring in the top 25th percentile nationwide will earn a certificate of recognition from the U.S. Department of the Treasury. Students scoring exceptionally high will win a National Financial Literacy Challenge Award medal (hey, this would look good on a resumé). And there are monetary rewards too. The Charles Schwab Foundation will award a scholarship of $1,000 to up to 100 students who get a perfect score of 100%. In addition, the Foundation will award $1,000 to each of those students’ schools.

For more information or to register, please follow the link below:
http://flc.treas.gov/index.htm

Just to make you smile, I am including here a test that is part of the newspaper advertising copy for this challenge.

A bond is:
(a) a British spy
(b) glue
(c) a type of loan that pays interest

Financial Literacy and the Current Crisis

I was asked in a TV interview whether financial illiteracy has contributed to the current financial crisis. I do not have data yet on the current crisis, but the data I collected last year on debt literacy indicate that many people do not know about the power of interest compounding and tend to underestimate how quickly debt can grow if one borrows at high rates. Most importantly, those who had low debt literacy were more likely to report having difficulties paying off debt. So, my suspicion is that individual debt illiteracy has played a role in the current crisis. Exacerbating individual lack of financial literacy has been the role played by those lending institutions that did not do their part in checking borrowers’ backgrounds or calculating how much debt those borrowers could really afford to take up.

And in this current world of derivates, ARMs, subprimes, and preferred stocks, it is even harder to understand what is going on in both individual accounts and in global markets and what people need to know in order to successfully navigate the financial system. In my view, we need to stick to a few fundamental concepts: the power of interest compounding, the effects of inflation, the principles of risk diversification, the incentives offered by the tax system. Knowledge of these simple principles can go a long way in helping us make sound saving and investment decisions.

People have been crying out that financial education is expensive. Well, bailouts can be even more expensive; I think we understand that now. But I have not heard of plans for any money to be allocated to improving financial literacy as part of the rescue plan. This is a pity because, having seen the consequences of illiteracy not only at the micro level but also at the macro level, we need education now more than ever.

If you would like to watch the TV interview (Financial Literacy and You), it can be accessed at: http://www.tvo.org/TVO/WebObjects/TVO.woa?video?TAWSP_Int_20081021_779352_0

Learning From this Crisis: A Discussion About Risk

As the financial crisis continues to unfold, it is important to reflect on the lessons we can learn from this experience and how those lessons can help us better manage household finances. In this blog, I want to focus on risk and risk management. Not only have prices in the stock and housing markets, in which many households invest, been gyrating, new financial instruments have made household balance sheets even more sensitive to the behavior of financial markets. For example, both the assets and the liabilities of households with adjustable rate mortgages, or ARMs, will be affected by a change in interest rates. Risk management is becoming more important than ever. Yet, according to several of the surveys on financial literacy I have conducted, the concept of risk diversification proves to be a difficult one for respondents, many of whom stated that they did not know how to answer to the survey question that dealt with this concept.

I want to discuss here the dangers posed by lack of diversification among the assets that are most common in household portfolios.

1. The danger of investing everything in a single stock.

One of the painful lessons that is right in front of us is the peril of investing in a single stock. Sure, all indexes are down and losses are large, but those who have invested solely in the stock of ailing banks now run the risk of losing everything. The importance of keeping a well-diversified portfolio should not be underestimated, particularly in the current situation. Clearly, in a crisis that is becoming global, most stock markets have been going down and portfolio diversification does not eliminate losses. However, it limits them and can provide a floor that prevents losses from being as extreme as they might otherwise be. While the experience of Enron stockholders may have been easy to forget, the magnitude of the current crisis should send a strong warning about the danger of putting all of one’s savings into a single stock.

2. The danger of investing everything in the house.

While we may not think of our house as an investment, in fact the house is often the most important asset we have. In some cases, it is the only asset people have. A large home, a nice backyard, plenty of room where our children can play are all features we want and cherish. However, when we buy, or when we plan to put an addition on the house, we have to consider what that will do to our portfolio. If we put everything we have into the house, we become very exposed to fluctuations in home prices. As the current experience shows, home prices can go down, and go down a lot! And we should not take comfort in the fact that we do not plan to sell our house any time soon. In the current labor market, mobility is important. Today’s workers change jobs many times in the course of a career, and one can hardly expect to be in one place throughout his/her lifetime. Moreover, and particularly in less populated areas, houses are not a good “hedge” against labor income risk. If a big firm in a small city goes under, local home prices are likely to drop. But this means that home values will decrease precisely when workers need their housing wealth the most: they may have to sell and move or they may need a home equity line of credit to offset the loss of employment income.

Risk is a part of our life, negative shocks happen, crises happen, and other shocks may lie ahead. More than ever before, we need to learn to deal with risk to insure the well-being of ourselves and our families.