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).


1. a) More than $102

2. c) Less than today

3. b) False

Tuesday, July 1, 2008

The Financial Literacy Initiative

It is official: Today marks the start of my “Financial Literacy Initiative.” Thanks to the support of several institutions, including Dartmouth College and the Financial Industry Regulatory Authority, I can now launch this new initiative. For those of you who have not followed my work closely, I have devoted my research in the past six years to financial literacy and topics related to financial literacy (for example, financial education). My work will not only intensify but will also aim to a large public. In this blog, you will read not only how to measure your financial literacy but also how to improve your financial literacy. You will also read about the results of academic research (not only mine but also those of other authors) that provides useful suggestions and recommendations for our financial decisions, and much more!

Let me start this initiative by summarizing as briefly as possible what I have done so far. My work will continue from here.

In collaboration with Olivia Mitchell from the Wharton School, I have documented an alarmingly low level of financial literacy among older people in the United States. In our sample of older respondents from the Health and Retirement Study, we find that over half of respondents cannot undertake a simple calculation regarding interest rates over a 5-year period and do not know the difference between nominal and real interest rates. An even larger percentage of respondents do not know whether or not a single company stock is riskier than a stock mutual fund. We have also shown that financial illiteracy is related to the inability to devise and implement financial plans. That is, one reason people fail to plan is because they are financially unsophisticated. Our work demonstrates that planning behavior can explain the differences in savings and why some people arrive close to retirement with very little or no wealth. This is only one of the disturbing consequences of financial illiteracy. Consumers with low literacy are also less likely to participate in the stock market, and they are more likely to have problems paying off debt.

Our work has also evaluated the role and effects of financial education programs. Most large firms, particularly those offering Defined Contribution pensions, offer some form of education program. The evidence to date on the effectiveness of these programs is very mixed. In our work, we find that seminars do affect wealth holdings. Estimated effects are sizable, especially for the least wealthy. Moreover, we have argued that it is not surprising that one retirement seminar may change behavior only modestly. The few available studies of the topic indicate how many seminars were offered or how many participants attended; in general, participants appear to attend only once or a handful of times. It is unlikely that widespread financial illiteracy will be “cured” by a one-time benefit fair or a single seminar on financial economics. This is not because financial education is ineffective, but because these programs are too small with respect to the size of the problem they are trying to address.

Our efforts to examine the causes and consequences of financial illiteracy have also been extended to datasets beyond the Health and Retirement Study permitting us to assess financial literacy and financial sophistication for many different groups U.S. respondents. For instance, with our cooperation, our questions on financial literacy have been incorporated into the National Longitudinal Survey of Youth and the Rand American Life Panel. We have also been successful in getting several European institutions to add similar questions to household surveys in their own countries. For example, a recent Italian Survey on Household Income and Wealth included some of these questions, and I have worked with the Dutch Central Bank to design questions to measure both financial literacy and financial sophistication in the Netherlands.

I have organized and continue to design new conferences that explore ways to increase the effectiveness of financial education programs. One very influential conference was held at Dartmouth College in October 2005 ( ) and a second at the NBER in Cambridge MA in May 2008 ( These two conferences brought together practitioners, policymakers, and academics from economics, psychology, and marketing. By examining data from newly available surveys and combining knowledge and experience from different fields, the conferences sought to develop new methods and strategies to improve employer-provided financial education programs. Information and insights from these conferences are described in the book that I am publishing this year and that compiles contributions of some of the most highly regarded experts in the fields of financial education, savings, pensions, insurance, and portfolio choice. This book, entitled Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs, examines not only the experience of the United States but also the experience of other countries, such as Sweden, Chile, and OECD nations. It is forthcoming from the University of Chicago Press.

Key Publications

The complete list of my publications and working papers appears in my CV posted on my web page. Some of publications that have been most influential include:
• My paper “Saving and the Effectiveness of Financial Education” was published in the book Pension Design and Structure: New Lessons from Behavioral Finance, eds Olivia Mitchell and Stephen Utkus (Oxford University Press, 2004). It was later reprinted in the Journal of Financial Transformation, vol. 15, December 2005.
• My study joint with Olivia Mitchell “Baby Boomer Retirement Security: The Role of Planning, Financial Literacy, and Housing Wealth,” appeared in the Journal of Monetary Economics in January 2007. This paper was awarded the Fidelity Pyramid Prize, a $50,000 award given to authors of research that best helps address the goal of improving lifelong financial well-being for Americans.
• The paper joint with Olivia Mitchell “Planning and Financial Literacy: How Do Women Fare?” appeared in the American Economic Review. It documents the very low level of financial literacy among older women in the United States.
• My paper joint with Peter Tufano “Debt Literacy, Financial Experience, and Overindebtness” has been widely cited in the press because it documents a strong relationship between financial illiteracy and debt problems.

And the effort will continue. More on the next blog!