Monday, March 17, 2014

Financial Literacy

The great difficulty with lifetime financial choices is that you only get to do them once. With lots of choices in  a market, like buying dinner or buying clothes, the choices are made and the consequences are experienced in a fairly short time. Mistakes are fairly small-scale. If you don't like the clothes or the restaurant, go somewhere else next time. Indeed, one of the ways that competitive market forces work to encourage value and quality is through this process of repeated (or not!) purchases. But in a single lifetime, you get to try out precisely one set of lifetime financial choices. If at age 50 or 60 or 70 or 80 you wish that you had done something different earlier in life, you can't go  back to your 20s and 30s and 40s and live it over again.

When I talk about "financial literacy" to make these choices sensibly, I don't mean anything too sophisticated--just the basics to get by. For example, consider a person who can't answer the following three questions, which are examples given by Annamaria Lusardi and Olivia S. Mitchell in "The Economic Importance of Financial Literacy: Theory and Evidence," published in the March 2014 issues of the Journal of Economic Literature. (Full disclosure: The JEL is published by the American Economic Association, which also publishes the Journal of Economic Perspectives, where I work as Managing Editor.) The JEL isn't freely available on-line, but many in academia at least should have access through a library subscription. Here's your three question financial literacy quiz:

  • Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow: [more than $102; exactly $102; less than $102; do not know; refuse to answer.]
  • Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent 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; do not know; refuse to answer.]
  • 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.” [true; false; do not know; refuse to answer.]

Remember, these questions are multiple choice, and you don't need to really understand the subject in any depth to make a plausible guess at the correct answers. These three questions were included as part of the Health and Retirement Survey in 2004, which is a nationally representative sample of Americans age 50 and over. Apparently, about one-third of Americans are able to answer all three of these questions correctly.

As Lusardi and Mitchell point out, many other surveys similar findings, and the young often do worse than their elders. However, it seems that most Americans are actually pretty optimistic about their financial literacy. They write (citations and references to tables omitted): "Even though actual financial literacy levels are low, respondents are generally rather confident of their financial knowledge and, overall, they tend to overestimate how much they know. For instance, in the 2009
U.S. Financial Capability Study, 70 percent of respondents gave themselves score of 4 or higher (out of 7), but only 30 percent of the sample could answer the factual questions correctly ..."

Of course, a lack of financial literacy has many costs. People don't save enough, so that they become more vulnerable if their car breaks down, or someone in the family gets sick, or loses a job.  They are also vulnerable to costly financial decisions. Instead of having a bank account, they end up paying high fees through pawn shops and payday loans. They often pay high credit card fees. They end up in costly arrangements when buying cars or appliances or houses, and when interest rates fall (as in the last few years), they fail to refinance their mortgage or other loans. They end up poor in retirement.

Regulators have in the past tended to respond to these issues by requiring more and more disclosure, but adding more fine print is not the superhighway to financial literacy. The harder challenge is to specify a smaller number of clear choices, with sensible default options that will work for most of those who choose note to make a choice. People have different needs and desires, so this isn't easy. On the other hand, people who function in 21st century America need to deal with health care choices, consumer electronics, software, map-reading, insurance, and lot of other issues. Most of them can manage the basics of financial literacy, too. But they need to learn it relatively young, because knowing when you're 60 what you should have done when you were 25 is not useful.

Many U.S. states have at least some elements of personal finance in their high school curriculum requirements, but it's not clear how well the lessons are being communicated, either to high school students or to adults interested in learning more. As Lusardi and Mitchell write: "Much work remains to be done. Very importantly, there has been no carefully-crafted cost–benefit analysis indicating which sorts of financial education programs are most appropriate, and least
expensive, for which kinds of people."