- 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: more than $102, exactly $102, less than $102?
- 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?
- 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.”
*Answers at bottom of post
These questions were part of the 205 US Health and Retirement Study (HARS). The Health and Retirement Study interviews 22,000 Americans 50 and over every two years on subjects like health care, housing, assets, pensions , employment and disability. In 2005, the three questions above were included in the study to assess the respondents understanding of compound interest, inflation, and stock risk respectively. If you answered all 3 questions correctly, you scored better than 66% of Americans who took the survey. This was absolutely shocking to me since I felt that the questions above were not only basic finance, but also basic mathematics. You can see more analysis of the results in a research paper written by Annamaria Lusardi and Olivia S. Mitchell. One has to wonder how much of a role this financial illiteracy (assessed in 2005) played in the 2008 Great Recession.
What can America do about this?
There are two schools of thought to combat financial illiteracy. The first school of thought is to include finance education in school curriculums. The author of the HARS paper states “In the same way we start people, you know, in school just reading and writing, you know, from the very beginning. We don’t teach literature so that people go on and write “War and Peace,” but we teach it so that people can appreciate a good book. ”
The other school of thought argues against finance education and to leave the understand of financial instruments to a higher level of financial advisors and through new regulations. Lauren Willis, a legal scholar who previously worked at the Justice Department and the Federal Trade Commission says “It’s sort of like saying, well we should start teaching everybody to be their own doctor, teaching everyone to be their own mechanic, you know, something like that, terribly inefficient to do that. Not only is it inefficient, but it has this sort of culture of blaming the consumer. You know, you’re the one who didn’t figure this all out.”
Where I Stand
Though I wouldn’t recommend anyone do their own surgery, or rebuild their car engines, I do think that basic financial education is important to the advancement and financial success of Americans in the future. Much like it would behoove one to learn how to change wiper blades or change an air filter in their cars, it is important for one to understand the basics of interest rates and inflation. Much like it would behoove one to learn how discern going to a physician versus taking Sudafed to treat a stuffy nose, it is important for Americans to understand the basics of stocks and bonds.
I think there is a level of basic knowledge that should be integrated into the curriculums of schools. Leave complex financial instruments to the experts, but one should know how to assess returns between a checking account, CD, or under the mattress. I like to believe that I have a basic understanding of finances, but there are other complex instruments that I will leave to the experts which is why I plan to allocate a portion of my assets to a hedge fund in the future. I don’t try to have a deep level of understanding on shorting, leverage, margin trading, short calls, long calls, etc., but I can evaluate a money market account, ETFs, mutual funds, growth stock funds, value stock funds, foreign investments, and dividends.
Did financial literacy cause the Great Recession? I think there were several causes to the recession and I won’t get into them right now, but it would be hard not to argue that people just didn’t have a clue about their understanding of the risks they were taking as they were signing mortgage papers. Yes, there were several mortgage brokers who were not transparent in their practices, but some blame lies with the financial illiteracy of the consumer.
- More than $102
- Less than today