I followed a link someone had posted on Facebook. Yes, yes I know it’s often a mistake, but since it mentioned financial literacy—or the lack thereof—why not? The headline, from a study referenced by CNBC, one of the great financial entertainment networks, was “70 percent of Americans can’t answer these 3 basic money questions“.
As I always try to do when presented with a provocative title, I read the original research paper behind it (Journal of Economic Literature 2014, 52(1), 5–44). I would advise everyone to do this at least once in your life. It is not fun, but you may think twice in the future before sharing a headline.
Thankfully, the headline looks to be true enough. There are some other interesting points in the paper worth mentioning. For example, ironically, most people’s self-assessment of financial knowledge is way off. The rough figure is a rating of four out of seven, and yet, the questions below cannot be answered by two out of three.
Let’s take a look, just to make sure we can answer them. Maybe not in the way they want.
The first has to do with whether you understand interest: “You have $100 in a savings account and the interest rate was 2% per year. After five years, what do you have?” The sad part is the possible answers: “A More than $102, B. Exactly $102, C. Less than $102”. They didn’t even ask you to do the math. If you read my book, Stop Being Poor, then you know the right answer is (A). Understanding compound interest is key to understanding the power of savings. You must continue to save over time without any break (removing money), or you will lose a lot of financial opportunity.
The second question is about inflation: “The interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy”. Answers: “A. More than today B. Exactly the same as today C. Less than today”. I think my readers know that as well. If a bank pays you 1% on your savings and inflation is 2%, then you aren’t saving. You are losing. The unmentioned part is “why”. The price inflation (increase) we see is a direct result of the policies and behavior of the Federal Reserve and the government. Primarily in the printing of money, making it worth less every year (answer C). Inflation is the increase of the amount of money. The secondary effect is the increase in prices.
The third question is: “Which is riskier, a single stock or a mutual fund”. They think mutual fund. On the most naïve math, they are correct. Yet they casually throw away the management fees they charge every year. No risk of avoiding that. It is actually possible to study a single stock and mitigate risk the best you can, but that is impossible to do with a fund. Nonetheless, my answer to that question is “neither”. Unless you can afford to lose money, stay out of the stock market.
I do find merit in much of the paper. They note that lower incomes promote lower financial knowledge. Sad but true. It is essential to take responsibility for this knowledge, no matter where you are right now. Else, you will pass on the same poor strategies. The less you know, the more you lose, like interest paid to others. Financial literacy can be just as weak in the highly educated, since an engineer, for example, does not receive specific college classes in personal finance. Doctors do not get trained how to run their practices. For the vast majority, we expect the government schools to have done that. Big mistake. The paper sites a 2009 study of grade school teachers, who admit that less than 20% felt prepared to teach financial education. Less than half of the nation’s high schools have such a program. I wonder why.
Even Ben Bernanke agreed in 2011, “financial education must be a lifelong pursuit that enables consumers of all ages and economic positions to stay attuned to changes in their financial needs and circumstances and to take advantage of products and services that best meet their goals.”
We are far from that, so glad you are here.
The paper concludes with musings about social conditioning to protect people from learning the truth and instead be “nudged” into signing up for tax-deferred plans like the IRA or the 401(k). These are all subject to limited access, taxation (at whatever rate the government chooses someday), management fees, and market volatility.
One conclusion of the paper is noteworthy: “Financial knowledge is a form of human capital”. This means your investment in understanding key financial realities is a value that can lead you to greater gains. It is worth the effort. To that end, Privatized Banking, and our way of thinking helps you not only save for retirement but also for all the needs and opportunities that can happen during the rest of your working life.