Are We a Nation of Financial Illiterates?

Let’s begin with two questions:

1. Do you consider yourself financially literate?

2. If so, how did you get that way?

And now, a third question:

3. How important is widespread financial literacy to the health of a modern society?

Before you answer the first question, take this little quiz, borrowed from the website of Annamaria Lusardi, a professor of economics at Dartmouth who knows and cares more about financial literacy than anyone else you’re likely to encounter:

1. 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?

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 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?

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 correct answers are …

a., c., and b. I am guessing that the vast majority of this blog’s readers got all three answers correct. But there’s probably money to be made in betting the opposite way.

Those three questions are the ones that Lusardi, along with Olivia Mitchell of Penn, have been inserting in a variety of major U.S. surveys. In a new working paper titled “Financial Literacy: An Essential Tool for Informed Consumer Choice?” (abstract here, download here), Lusardi writes that among respondents age 50 and older, only half of them got the first two answers right and only one-third of them got all three answers right.

Because Lusardi, Mitchell, and many other economists focus on retirement behavior, it is pretty horrible news to learn that so many older people are ill-equipped in the basics of saving and investing. With most U.S. companies doing away with big employee pensions (see Roger Lowenstein‘s new book While America Aged), more and more people have to plan their own retirements. I share their concern but I also think that too much emphasis is put on retirement know-how. It’s not that saving for retirement isn’t important; but by the time you’ve woken up to the fact you have no idea what you’re doing for retirement, you’ve probably already bungled a lot of financial decisions. Which brings us to:

Question No. 2: If you are financially literate, how did you get that way?

I’d like to think I’m at least adequate in taking care of my family’s finances and everything that includes in the modern world: real-estate and insurance decisions, saving for college and retirement, investing and tax planning, etc. But it has been a bit of trial-by-error mixed with trial-by-fire — and to be honest, I was very fortunate to have an older brother who is smart, frugal, patient, and who worked for many years in finance. If it weren’t for him, I’d be in considerably sadder shape.

But here’s my point: I’m not exactly undereducated. I had 13 years of public schooling, 4 years of college, and another 2 years of graduate school — and after all that schooling, I don’t know if I learned enough to answer all three of Lusardi’s questions correctly. The subjects simply didn’t come up. Just as they apparently didn’t for the two-thirds of the older respondents to Lusardi’s questions.

The good news is that economics is being taught much more in high school now than it was 20 or 30 years ago. (While “economics” is of course not the same as “personal finance” or “financial literacy,” let’s for the time being pretend that most economics courses give students a rudimentary understanding of personal finance.) According to the National Assessment of Educational Progress (“The Nation’s Report Card”), 9 of 10 high-school students said they were exposed to some economics education, up from 1 in 4 in 1982. According to the National Council on Economic Education, 17 states now require students to take an econ course to graduate, up from 13 states in 1998.

So how’s it working? Not very well. According to the latest annual survey by the JumpStart Coalition for Personal Financial Literacy, “high school seniors correctly answered only 48.3 percent of the questions,” down from 52.4 percent a year earlier.

As Lusardi points out in her new paper, there is a vast — if perhaps unsurprising — split in the population: “Those with low education, women, African-Americans, and Hispanics display particularly low levels of literacy.”

Which brings us to Question No. 3: How important is widespread financial literacy to the health of a modern society?

Well, I would say very. So would Lusardi. When you have a society with a modern and fairly complex financial system, it’s probably not a good sign that more than half of the citizenry can’t handle even the basics: how a credit card actually works (I know some teenagers, e.g., who really think it’s “free money”); the beauty of compound interest and the ugliness of paying the minimum balance on a credit card; how to save and invest even when you don’t think you can; how to learn the amount of insurance you need, etc. Lusardi wonders whether people shouldn’t be required to get a license in order to take out a mortgage. That certainly would have dampened the subprime mess a bit, yes?

And we haven’t even touched upon the most basic macroeconomic issues like supply and demand, etc. Can you imagine how different the shrill news coverage of rising gas prices would be if the public (and the media) cared even just a little bit about how the economy actually works?

A lot of behavioral economics, including the good ideas in Nudge, is about cleverly correcting harmful human tendencies — but many of these tendencies need correction only because so many people are so undereducated in such matters.

I am all in favor of a well-rounded education, but seriously: what good is it if high-school students learn about Flaubert, biology, and trigonometry if they don’t learn how to take care of their money? One bright side to the increasingly dark economic news these days is that more and more people will learn (albeit the hard way) Rule No. 1: Do not buy what you cannot afford.

So what’s to be done? I turned to Lusardi with a few questions; her answers are well worth reading. I’d also be interested in hearing your ideas in the comments.

Q: How does U.S. financial literacy compare to other developed nations?

A: This is a difficult question to answer because, as you may know from my work, almost no (national) survey has (or had) information to measure financial literacy. Moreover, we do not have a consistent set of literacy questions across countries. However, judging from some work I have been doing comparing the U.S. with the Netherlands and Italy and the O.E.C.D. Report on Improving Financial Literacy, I can say that other developing nations face the same problem of widespread financial illiteracy. If anything, financial illiteracy in other countries is worse than in the United States.

Q: Was there ever a time when financial literacy was better taught in U.S. schools? (I believe that “home economics,” back when it was born, included some home-finance component, didn’t it?)

A: Some type of consumer education has been present from the early years (1930’s and 1940’s). Between 1957 and 1985, 29 states adopted legislation mandating some form of “consumer” education in secondary schools. Fourteen states specifically required coverage of topics relevant to household financial decision making, from budgeting and credit management to balancing checkbooks. Yet, if you read the results from the JumpStart Coalition Survey of Personal Financial Literacy, financial knowledge is very low in high school and not improving.

Because of this evidence, some have argued against teaching financial literacy in high school (and against financial literacy education in general). In my judgment, this is premature. In fact, this evidence can be interpreted as showing that we need to improve the way in which we teach financial literacy in school.

Q: I would argue that teaching kids biology, trigonometry, and literature may be less useful than teaching basic financial literacy; what are the barriers to doing so, and who is trying hardest to make this happen?

A: I do not think that literature and mathematics are less useful in the lives of people than financial literacy. In my view, financial literacy should not replace these courses (in fact, some financial literacy can be integrated into mathematics), but should be added into the curriculum with the same high standing. As students study Faulkner or Steinbeck, Madame Curie or Louis Pasteur, they can also study Milton Friedman. In my view, as I will explain more below, we need to stay away from things like how to balance a checkbook and teach about the workings of the economy. We do not teach how to bake a cake in high school. It would be useful to know how to cook (please see statistics about obesity), it would add to the lives of people, and moms are now working full time and have stopped teaching that, but these practical matters should stay out of schools.

Among the barriers about teaching financial literacy in school are 1) lack of resources and financial support (and we need well trained teachers); 2) the fragmentation of the legislation (most of the decisions about curricula are done at the state and local level); and 3) the lack of consensus about what to teach (many institutions, including banks, are devising high school curricula and there is a wide spectrum of curricula out there).

Both the National Endowment for Financial Education (N.E.F.E.) and the National Council of Economic Education (N.C.E.E.) are doing good work to raise awareness and introduce financial education in school.

Q: If you were president of the U.S. for a day (or longer), what are 5 pieces of financial literacy that you’d try to have taught to everyone?

A: If I were president for a day, I would like the following topics taught in high school:

1. Basics of how markets work. Things like: it is the law of demand and supply that determines prices in competitive markets, and the interest rate is the price of money.

2. Time value of money and the working of interest compounding: Because so many payments in finance happen at different points in time, one needs to know how to compare payments. Discounting is at the basis of asset pricing. What is the price of bonds? It is the present value of its payments. Interest compounding is a fundamental concept and it requires a little bit of math. It is critically important to understand interest compounding to be able to fully appreciate the importance of starting to save young and how to borrow and handle debt.

3. The concept of risk and the working of risk diversification and insurance: A lot of the decisions about saving and investing have to do with how to handle risk.

4. Basic accounting: To know the net values one needs to subtract assets and liabilities, and that it makes a big difference between whether we choose market prices versus book prices.

5. Rights and responsibilities of consumers and institutions. People need to know there is a Federal Deposit Insurance Corporation, bank deposits are safe (up to $100,000), and there is no need to line up to withdraw deposits; they should know who does and does not have fiduciary duties and what it means to use a financial advisor (you cannot sue them if the stock market plummets).

These are rigorous topics, there exists a lot of first rate academic research on them, and they deserve a seat in high schools. In other words, yes to financial literacy and without apology!

If I were president for another day, I would also do the following:

1. Have federal, rather than state and local policies, about financial education: Why should Nevada have a different curriculum than New Jersey; Does interest compounding work differently in New Jersey?

2. Make the financial industry stay out of the process of devising curricula and financial education in general. It is a problem of incentives (they do not face the right incentives). This is a job for non-for-profits and academics and it is critically important to have independent players.

3. I would make sure teachers are equipped to teach and resources are allocated appropriately (at least get the same money as other topics). Having the gym teacher do financial literacy education defies the purpose of having financial education in schools.

[Note: I discussed this topic on the public-radio program The Takeaway.]


claudia parliament

suggested reading on wednesday

frankenduf

question 4. Which name doesn't belong: Faulkner, Steinbeck, Curie, Pasteur, Friedman.

Yannai

Obligatory SNL Skit link:
Secret to Getting and Staying Out of Debt: Don't Buy What You Can't Afford

http://consumerist.com/consumer/clips/snl-skit-dont-buy-stuff-you-cant-afford-252491.php

Sadly, the best educational film ever made on teh subject.

Earl

Teaching financial literacy that's applicable to contemporary life is actually much easier said than done. Though we think financial savvyness has something to do with knowing the basics of compound interest, supply & demand, the reality is much more complex given the changing landscape of financial services.

Each credit card, bank, and financial institution offers a wide variety of products with different terms, rates, and fees. New financial products proliferate every year. No educational system could possibly keep up with the maddening array of financial products that are brought into the market place every year.

The current mortgage crisis is a case in point: Many of the new mortgages were sold to borrowers using short terms ARMs-- a financial product that was only recently invented. These products were financed with CDOs that were given AAA ratings, duping even experienced, risk-averse investors.

I wish financial literacy were as simple as answering the 3 questions listed in this post- but alas, it seems horribly out dated.

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Hanna

I'd propose to teach not only financial literacy, but economic literacy in general. The main idea of such a course should be to teach people analyze where goods and their prices come from. People should understand well the basic economic concepts like resources, scarcity, demand, supply, price, market, added value.
And all these things need to be explained in an effective way, without too many scientific terms and too complex mathematics, but instead with simple words, brain-stimulating questions and vivid examples, preferably from real life, and also, if possible, with some simulations of real-life situations.(Well, actually, both the content of this course and the methods of teaching it should be very closely connected with real-life problems, like the risk of getting into a financial pyramid, the need to analyse politicians' promises etc.)
The way of teaching is really important, for otherwise nobody will understand anything (well, they will write tests according to the algorythms that they were taught, but they will not have genuine understanding, i.e. "feeling", of what economy is about).

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Robert D. Diamant

I'm the Economic Education Specialist at the Federal Reserve Bank of New York. We have a series of economic/financial literacy programs for students grade 4-college.The program for grades 4-6,"It's All About Your $," incorporates material about the barter system, U.S. and foreign currency, counterfeiting, budgeting and saving. We work in conjucntion with teachers in the 2nd Federal Reserve District (NY State, northern NJ and southern CT.) Our programs are based upon local and national standards. "Money" is an incredible motivation that a talented educator can use to get students at an early age thinking about various compoents of "financial literacy." Check out our website at "www.newyorkfed.org" for details about our financial and economic literacy programs.

praxis22

1. Yes
2. 10 years of study, (after LTCM)
3. I guess that depends on your politics. Personally, yes.

Chris

1. Yes
2. Other than common sense things like "saving is good" and "don't spend beyond your means", it wasn't until I took a financial literacy course in college that I got a solid grasp on managing my finances.
3. Widespread financial literacy is very important, otherwise you'll see things like people taking on mortgages they can't possibly afford and we can't let that happen... oops.

Davey

It is axiomatic that we are financially illiterate. In fact, in the sense of being well-read and thoughtful individuals, we are a nation of illiterates. At the root of financial or economic literacy (hell, at the root of common sense) is the need for critical thought. On a day-to-day basis, we don't think about what we will do. See the following from #50 ssolsen, above. Can you spot the non-thinkers?

"Bottom 20%–Nigerian Bank Scheme or pyramid scheme
4th 20%–Credit Card Balance Transfers
3rd 20%–Lottery Tickets
2nd 20%–Checking Accounts
Top 20%–Debt, equity, mutuals and ETF's"

He left out the rent-to-own furniture people and the people who consolidate all of their debts into "one easy monthly payment!" One payment must be better than 10, right?

A E Pfeiffer

"I am all in favor of a well-rounded education, but seriously: what good is it if high-school students learn about Flaubert, biology, and trigonometry if they don't learn how to take care of their money?" It doesn't have to be a case of either/or; cf. Mr. Micawber in Dickens' "David Copperfield: "Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery." That's a pretty good illustration of "Rule No. 1: Do not buy what you cannot afford."

AND there's the added mathematical challege of a non-metric system!

Mary

A significant percentage of divorces are caused by money problems. This topic is so important to couples, families, children, retirees-to-be, etc., that society should support profound change to resolve this fundamental problem rather than just uttering "tish, tish, pity" about it in a blog. Any ideas?

alex

i'm a communist. i don't need financial literacy. that what the government is for.

Jason Ping

Incentives: Give someone a decent salary, and I'll bet that the chances they become financially literate will go way up. If you don't have money in the first place, you probably won't be inclined to learn about money management.

I have spent most of my life financially illiterate. Well, I knew my bank charged me ridiculous fees for going under a certain minimum, and I knew my credit card company was loving it whenever I couldn't keep up with my payments. I knew that starting to invest young was important to financial security, and I knew that insurance was something I could come to deeply regret not having. Mostly though, my thoughts about personal finance were limited to deciding what I really needed and what I could get by without so that I could make it to the next paycheck.

Then I got a job with a slightly better salary. Within weeks I knew all about retirement plans, investment, finding the right bank account, insurance, etc.

There's no incentive to be financially literate when you live paycheck to paycheck. And yes, thrift and restraint are problems for many folks, but the idea that people's money troubles are always brought on by their own irresponsibility is simplistic.

Having said that, I could have avoided some of my own money problems by not buying so many non economics books. But I still value my Flaubert, biology, trigonometry, and the like far more than the compounded interest I may have sacrificed to learn them. Mushy talk about a fuller life aside, my non-economic pursuits eventually led to a higher-paying more rewarding job. . . . And that led to my financial literacy.

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Mikko

Financial illiteracy was also discussed in the media in Finland earlier this year after Danske Bank surveyed 18-19 year olds in the Nordic countries on some of the basic concepts of personal finance. The result was that about half of the respondents didn't know what the interest rate is.

As a recent business school graduate I'm surpised that half of the respondents actually got it right considering how the multiple choice answers were formulated:

Q: Do you know what the interest rate means?
a) Yes, it's a fee charged by a bank
b) Yes, it's a fee that accumulates as a result of borrowing money
c) Yes, it's the price of borrowed money
d) Yes, it's a fee the government charges for borrowing money
e) None of the above
f) I don't know

I would assume that to the vast majority of people who think of the interest rate in everyday terms (borrowing and banks) all of the first three options sound about right. However, strictly speaking c is the only correct answer (Hopefully I didn't lose anything in the translations).

I guess my point was that I wish the survey had used questions similar to Lusardi's, which I think would have given a much more relevant picture of the understanding of these concepts here in the Nordic countries.

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bbd

I'm in my early 60's and have been on Wall Street my entire working life, mostly as a financial adviser to individuals, retirement plans, endowments, etc. After all these years, it never ceases to amaze me how otherwise very successful and affluent people can be so ignorant of the basics of personal finance. It is not unusual, for instance, for me to encounter people with what most of us would consider a great deal of money in liquid form (I'm talking millions), yet have mountains of credit card debt or have most of their money languishing in checking accounts earning no interest at all. I have to politely explain to them in quite simple terms why it is just plain dumb for them not to pay off such debt. These are not "trust fund babies" or people who won the lottery, but businessmen, high-level executive types and professionals.

RT1

Money problems cause divorces? More likely unrealized expectations, fault finding and the blame game. Hardly anyone has money starting out but I'll bet a lot of couples look back and say that was the happiest period of their lives. You can't eliminate the grinding desperation people feel when they want things they don't have or sense they are running out of time to make their lives better. Society can't change individual choices. Short of housing everyone, feeding everyone and guaranteeing a job and health care there is no cure for money problems. Besides wise counsel often falls on deaf ears. Anyone who's raised a child has witnessed that.

agitator

when obama becomes president we'll all become financially literate, just like magic, because we can. yes we can! he's a magic man, a man with a plan; indeed, he's the magic man.

Tomas

Why would we expect a socialist government near-monopoly school system with teachers (often leftist themselves) who are forced to be in a union to be able to provide any level of truth regarding economics?

It is like expecting evolution to be properly taught at a fundamentalist christian private school.

Eric

I have an MBA and I think I know a thing or two about money (the questions were certainly easy) but that doesn't mean I manage my money correctly. Too much emotional baggage goes into how and what we spend our money on.

Lately I've been watching a video series by Dave Ramsey and I'm convinced some common sense tough love kind of education like that is exactly what high school students (and most adults for that matter) need.

Jessica

I really enjoyed reading this article, and am happy I got all three questions right! (though I was a little nervous for a moment) It is true that many people don't even know the basics about taking care of their money. I have many friends that just spend spend spend, while living paycheck to paycheck, and wonder why they do not have money when something big happens in their lives. www.etfmarketpro.com provides free financial information to the investor who needs just a little more education. It is a very good resource!