Wednesday, August 20, 2008

Are We a Nation of Financial Illiterates? Some Comments

Stephen Dubner, one of the authors of Freakonomics, has posted an article on his blog (link is just below) that addresses this question: Are we are a nation of financial illiterates?

If you have read Freakonomics, you know he is a gifted writer. In his blog, he poses three critical questions. I modified these questions slightly (they are listed below), and added some discussion.

1. Are we a nation of financial illiterates?
2. How did we get that way?
3. How important is widespread financial literacy to the health of a modern society?

The answer to the first question is unfortunately a yes. In surveys after survey after survey, we find that the majority of the U.S. population lacks knowledge of some of the most fundamental financial concepts, such as the power of interest compounding, the workings of risk diversification, and basic asset pricing. In one of my most recent surveys, I measured “debt literacy,” or knowledge of the concepts related to debt and borrowing. Results are humbling: only one-third of the population has a good grasp of the workings of credit cards and understands how quickly credit card debt can grow when borrowing at the standard rates.

The answer to the second question is more complicated. While the quality of schooling education in general may be cause for concern (relevant statistics are not comforting), the financial landscape in the United States has changed dramatically in recent decades. One of the most notable changes has to do with retirement planning. In the past, the average worker did not have to make any decisions about his or her pension. Pensions were mostly defined benefit plans entirely overseen by the employer, so there was little incentive or rationale for individuals to learn about saving and investment. Today, the average worker needs to decide how much and how best to save for retirement—a decision that can be daunting and, if implemented poorly, that can result in inadequate preparation for retirement. Thus, the incentives and the reasons to learn how to save and invest were less pressing. Similarly, until quite recently, the financial instruments that people needed to deal with were fairly basic. When purchasing a new home, a typical household in the 1960s or 70s would likely get a 30-year fixed rate mortgage from a local bank. Today, the complexity of mortgages has increased dramatically and so has the number of lenders, making the process of financing a home a much more complicated endeavor. So, in answer to the question—how did we come to be a nation of financial illiterates?—perhaps it’s not that we have become less financially literate than in the past, but that the world around us, with it’s increasingly complex financial instruments and increasing demand for personal responsibility, is changing.

The answer to the third question—how important is financial literacy to the health of modern society?—is not an easy one either. It is difficult to assess the effects of financial literacy. Financial literacy is not distributed randomly among the population; it is often the result of personal choice, of parents’ education, and of an individual’s access and exposure to financial education. There are very few experiments we can rely on to assess whether or not financial illiteracy results in financial mistakes. Nevertheless, studies consistently show that those who display low levels of financial literacy are less likely to display healthy financial behavior. And in the modern economic system in which we all live, we have to make sure we are well equipped to make the financial decisions that confront us.

Coming back to Dubner’s blog, I am happy to see that it has generated a lot of comments (more than 200 as of today). One reader responded to Dubner’s posting with a fourth question (slightly modified here):

4. Which name doesn’t belong: Faulkner, Curie, Pasteur, Friedman?

My answer is Faulkner. The other authors have made important discoveries that have shaped science and public policy. One of the remarkable lessons we have learned from Milton Friedman is that “inflation is always and everywhere a monetary phenomenon.” This means that if the central bank does not change the money supply, prices will not keep increasing, even in the presence of an oil shock. Now, this is pretty useful to know, don’t you think?

Tuesday, August 5, 2008

Why Financial Literacy Matters

In my previous blog, I posted three questions that can be used to measure financial literacy. In this posting, I want to discuss the answers to those questions and why getting them right matters.

The first question is:
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?

This question measures numeracy and knowledge of the power of interest compounding. The fact that interest grows on interest is an important concept to understand and explains how your investment can grow quickly over time.
There are two lessons to be learned from this concept:
1) To make the power of interest compounding work in your favor, it is important to start to save when you are young. Just a simple example: $1 invested at a 7% interest rate increases more than 7 fold in 30 years. This is pretty good, yes? (But see discussion of inflation below.)
2) It is important to borrow as little as possible with credit cards or through other high cost means. Borrowing at an interest rate of 20% means that it takes fewer than 5 years for your debt to double. To me, this seems to quickly hurt.

The second question is:
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?

This question measures knowledge of inflation. Inflation is simply the change in prices overtime. If prices increase, it means you can buy less with your money.
There are two lessons to be learned from this concept:
1) You need to protect against the erosion of your purchasing power. Because of inflation, the money you have today will buy less in the future, so you need to invest your money at an interest rate that is higher than the inflation rate. If inflation is at 3% and you earn 1% on your savings account, believe me, you are not doing well!
2) It is important to take inflation into account when planning for the future. In other words, do not expect the prices tomorrow to be the same as the prices today.

The third question is:
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.”

This question measures knowledge of risk diversification. This is a very important concept that relates to the old adage 'don’t put all of your eggs in one basket.' A simple fall and you have a "frittata," as we say in Italian.
Again, there are lessons to be learned from this concept:
1) Make sure that a single event does not put a big dent in your investment. For example, why invest in a single stock? Why give all of your money to your brother-in-law who wants to open a cigar shop? Firms can fail and people can stop smoking.
2) Investing in your company stock is very risky; if your company goes under, you will lose the money you invested when you need it most. Even if you like your company a lot, why take so much risk? Clearly, I am lucky; Dartmouth is not listed on the NASDAQ and I do not have to face this decision.