Financial Literacy

by on May 21, 2014 at 7:22 am in Books, Economics, Education | Permalink

Consider the following three questions (from Lusardi and Mitchell):

1. 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? Do not know. Refuse to answer.

2. 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 not know. Refuse to answer.

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.’

T. F. Do not know. Refuse to answer.

Sadly, most Americans rate themselves high on financial acuity but they cannot answer all three questions correctly.

Only about a third of Americans answer all three questions correctly (and that figure is inflated somewhat due to guessing). The Germans and Swiss do significantly better (~50% all 3 correct) on very similar questions but many other countries do much worse. In New Zealand only 24% answer all 3 questions correctly and in Russia it’s less than 5%.

Some of the variation can be explained by experience. The Japanese, for example, don’t have much experience with inflation in recent decades and they perform poorly on that question. The questions, however, can hardly be considered esoteric and a large literature indicates that the ability to answer these questions correlates with the ability to intelligently make real and important financial decisions regarding mortgage refinancing, credit card borrowing, and retirement planning.

Most states now require that financial literacy be taught to high school students and there is some evidence that teaching financial literacy improves financial outcomes later in life but the evidence is not strong and most teachers still feel that they are unqualified to teach the basic concepts.

In my opinion, improving financial literacy is one of the areas in which principles of economics teachers can make a great contribution to their students. Modern Principles, my text with Tyler, contains extensive material on these topics including a chapter on stock markets and personal finance but more needs to be done.

Addendum: Take the quiz here (with a few more questions). Hat tip: PD Shaw and Tim Ogden for an added link.

F. Lynx Pardinus May 21, 2014 at 7:29 am

I was little worried about the use of “stock mutual fund.” That’s a pretty broad category, including things like a hypothetical actively-managed emerging-market microcap sector fund. Luckily they hedge with the word “usually.”

mulp May 21, 2014 at 2:24 pm

I’m more worried about the use of “savings account”. Clearly that use is based on the days of Regulation Q and toasters as premiums for opening up a savings account.

From experience, I know a savings account with $100 in it in the 21st century will be most like $0 after 5 years. Maybe you could reclaim money from the State Sec of Treasury who administers the abandoned assets expropriation funds, but it would be reduced by bank fees far in excess of any interest.

Banks no longer make money on the spread between savings and secured debt. Instead they make their money on churn – you need to pay transaction fees money money out of (and maybe into) savings, and what would be loan sharking when question 1 made sense, now called “credit cards” and payday lending.

Americans who must survive on the low wages Alex and Tyler think they deserve have learned banks are only going to take all their money, or refuse to do any transactions with them. A low wage worker paid by small business check with probably not be able to cash that check even at the bank its drawn on. Might be able to deposit into a savings account, but then not be able to take it all out even after three days because a monthly account fee will be due.

Willitts May 21, 2014 at 11:50 pm

Banks don’t earn income on spread (aka net interest income), but churn (part of non-interest income)?

Have you ever actually looked at a Uniform Bank Performance Report?

David May 21, 2014 at 7:45 am

The last question is phrased in a very American way. I hope this was not lost in translation.

Willitts May 21, 2014 at 8:34 am

What is the non-American way to phrase it?

dan1111 May 21, 2014 at 8:45 am

Glauben Sie, dass die folgende Aussage wahr oder falsch ist? Der Kauf eines einzigen Aktien des Unternehmens in der Regel bietet eine sicherere Rendite als ein Aktienfonds.

yo May 21, 2014 at 9:00 am

… bietet in der Regel… Deutsch ist schwer, Dan.

Das May 21, 2014 at 9:17 am

This *exactly* is the problem. Using google translate isn’t enough.

dan1111 May 21, 2014 at 9:44 am

Well, it seemed to be enough for the joke. I probably should have chosen a more obscure language, though…

Willitts May 21, 2014 at 11:55 pm

I appreciated the joke, and I understand enough German to get it, regardless of whether the grammar and verbiage were ganz perfekt.

alexh May 21, 2014 at 12:45 pm

If the researcher wrote the survey in NZ (who are cited as doing worse than Americans) the question – if similarly sloppily written – might instead say “…than an equity unit trust”. (Probably the relative poor showing of USA vs NZ would invert in that case.)

Cyrus May 21, 2014 at 7:48 am

Joining the chorus that 3 is badly phrased.

corbett May 21, 2014 at 8:48 am

so there’s a significant problem with this Lusardi and Mitchell survey … immediately obvious in question wording. rest of the methodology is likely worse, but the details are blocked by a membership wall in the unhelpful reference.

honest, broad conclusions on financial literacy can not be made from invisible conjecture and casual surveys — it’s just social gossip at best

The Other Jim May 21, 2014 at 8:51 am

And also a rather dumb question to ask. Everyone should know the terms bank account, interest and inflation. Plenty of people can, and do, get through life without knowing what a “stock mutual fund” is.

A better question would be something about paying off debt.

PD Shaw May 21, 2014 at 9:03 am

I agree that the questions appear to skew towards investment knowledge; there is one that Alex didn’t list that has to do with comparing a 15 yr and 30 yr mortgage. (See my link to five question quiz below)

Watchmaker May 21, 2014 at 9:10 am

“Diversity is good” is an immensely important piece of knowledge.

T. Shaw May 21, 2014 at 1:18 pm

I think you mean “diversification is good.”

Risk diversification is one one the basic tenets of financial management.

zbicyclist May 21, 2014 at 9:18 am

+1. I wonder what % of households in each country own stock mutual funds?

Slocum May 21, 2014 at 4:27 pm

Including as a part of a 401K? More than half:

http://www.csmonitor.com/Business/2013/0508/Dow-hits-15000-but-percentage-of-Americans-owning-stocks-hits-a-low.-Why

And that’s an underestimate, since many people own mutual fund shares in retirement accounts that are not ‘self directed’.

Slocum May 21, 2014 at 4:28 pm

For the U.S. that is (where’s my edit?)

Joe Smith May 22, 2014 at 10:28 am

Question number 3 is so badly worded as to be meaningless and says more about the financial ignorance of the people who prepared the test than the people who tried to answer it.

Andrew' May 21, 2014 at 9:38 am

Okay, this is proper wording for the survey:

“For an individual company stock compared to a stock mutual fund, the beta of A over B averaged over the full market cycle is what?”

>1, >1, 1, indeterminate

Norman Pfyster May 21, 2014 at 10:18 am

That was pretty much my thought, too. The tricky part fo the question isn’t “what is a stock mutual fund?” it’s “what is a safer return?” By safer, I guess they meant less volatility or higher likelihood of matching market returns, but by that point, I was thankful for having taken corporate finance and portfolio theory classes, which seems a bit much to expect from most people.

Willitts May 22, 2014 at 12:10 am

If people don’t know the vernacular, they’re not going to understand the technical definitions.

The issue here is only whether “stock mutual fund adequately conveys the idea of a diverse portfolio. “Stock market index fund” would be more accurate, but would they know what an index fund is?

“Portfolio of many different stocks” would probably be best.

DPG May 21, 2014 at 1:48 pm

99% of people outside of finance don’t know what beta is.

Andrew' May 21, 2014 at 2:31 pm

That’s why it’s funny!

Marie May 21, 2014 at 2:32 pm

It’s a fish. Comes in a little bowl at Walmart.

Different Marie May 21, 2014 at 4:49 pm

It’s side slip in aviation. And it’s route/problem advice in rock climbing. And a version release in software development (or something like that).

So the finance definition and the rock climbing definition of beta are the most similar?

byomtov May 21, 2014 at 6:47 pm

Huh? What is the calculation you are describing?

And what does beta have to do with this? A stock with beta=1 is still riskier than an market-wide index fund.

andrew' May 22, 2014 at 6:51 am

I don’t believe in the concept of risk!

byomtov May 23, 2014 at 1:12 pm

OK then. Why are you discussing it?

Beliavsky May 21, 2014 at 11:39 am

I think the question is OK. It is testing understanding of diversification, which is a very important concept. The vast majority of people who invest in stocks should be doing so through diversified open-end mutual funds and exchange-traded funds rather than picking stocks themselves — because the former is “safer” (has lower volatility).

Jay May 21, 2014 at 11:56 am

Yes, we know what the questing is TRYING to ask, people are claiming it is badly worded for its purpose. There are much simpler ways to test diversification than using vague phrasing like “safer return” and “stock mutual fund” which change the quest into knowing what a mutual fund is relative to a single stock (which is not brain surgery but definitely not the purpose of the question).

dbg May 21, 2014 at 11:48 am

question 3 is phrased so as to be obvious to a person who has read the often-repeated line in Intro to Finance textbooks “bond price is inverse to interest rates”.

the goal of the quiz is to test for basic financial literacy, i.e. whether or not a person has read an Intro to Finance textbook. if that’s what they’re testing for, the question seems perfectly phrased.

Axa May 21, 2014 at 7:53 am

Financial education? Education is supposed to make you think, make you free, not a slave of the system, hahaha. It’s a nice paradox the people most affected by no so smart financial decisions have no other help but “common sense”……because they reject the knowledge.

Ps. What about the people that is never going to take an undergrad economics course? It makes me remember a quote from a japanese mathematician that has a TV show to popularize science. Teachers need to recognize good students and get out of their way. The people that really needs help (with math) are the ones that are not in the classroom.

Jeff May 21, 2014 at 8:14 am

The Russian respondents must have been deliberately misleading the questioners, since random guessing should result in 12.5% getting all three correct.

F. Lynx Pardinus May 21, 2014 at 8:24 am

How do you get 12.5%? I get 1/3*1/3*1/2 = 5.6%

Jeff May 21, 2014 at 8:31 am

I don’t consider a “do not know” answer to really be a guess. But since that would still result in not getting credit for a correct answer, it should be 1/3*1/3*1/3 = 3.7%.

I still think the Russian respondents are likely misleading the interviewers though, this is the country that is NASA’s lifeline to the space station, put probes on other planets, builds world-class aircraft, etc.

F. Lynx Pardinus May 21, 2014 at 8:35 am

The last question is a true/false question. If someone is guessing randomly (not counting do not know or refuse), I think the probability should be 1/3*1/3*1/2

Willitts May 21, 2014 at 8:39 am

The average Russian is not comparable with the Rocket Science Russians.

Misleading is certainly a possibility, but why do you suppose Russians dispropotionately mislead?

They are highly superstitious people.

Widmerpool May 21, 2014 at 9:26 pm

I asked my Russian wife, who holds 3 degrees, she couldn’t answer.

Willitts May 22, 2014 at 12:13 am

My Lithuanian wife got it right, but she is married to an investment advisor. :)

dan1111 May 21, 2014 at 8:48 am

@Jeff, it might be due to widespread misperceptions rather than intentionally being misleading.

Kim Lee May 21, 2014 at 8:23 am

Mortgage default rates were higher among people who could not correctly answer these questions.

1. In a sale, a shop is selling all items at half price. Before the sale, a sofa costs $300. How much will it cost in the sale?
2. If the chance of getting a disease is 10 per cent, how many people out of 1,000 would be expected to get the disease?
3. A second hand car dealer is selling a car for $6,000. This is two-thirds of what it cost new. How much did the car cost new?
4. If 5 people all have the winning numbers in the lottery and the prize is $2 million, how much will each of them get?
5. Let’s say you have $200 in a savings account. The account earns ten per cent interest per year. How much will you have in the account at the end of two years?

http://www.frbatlanta.org/documents/pubs/wp/wp1010.pdf

Dan Weber May 21, 2014 at 8:54 am

#4 has been covered before on this blog, with a graph showing the dramatic fall-off in correct answers as the cohort ages, but I couldn’t google it up.

Michael B Sullivan May 21, 2014 at 11:22 am
Neal May 21, 2014 at 9:00 am

How much of this is because people just don’t read the questions?

Mike May 21, 2014 at 10:07 am

I bet you’d find a correlation between people who don’t carefully read the questions and people who don’t think they’d know the answer if they did. There may also be a correlation between people who don’t carefully read and consider these questions and those who don’t pay their mortgages (for whatever reason).

cheesetrader May 21, 2014 at 9:23 am

#3 is bogus – you can’t buy Yugos anymore

dan1111 May 21, 2014 at 10:17 am

Yes you can…at a second hand car dealer!

Brandon May 21, 2014 at 10:16 am

#5 doesn’t specify simple or compound interest!

Hasdrubal May 21, 2014 at 10:33 am

Where do you bank that pays simple interest? How is the bank going to calculate simple interest, when you withdrawal from the account does your withdrawal come from interest or principal?

Willitts May 22, 2014 at 12:18 am

Once you receive earned interest, it becomes principal. It sounds facile, but it is a common and serious misconception to both investors and gamblers.

Jonathan May 21, 2014 at 11:02 am

1 is easy.. $300 (I’ve seen these sales before.)
2 All of them expect to get the disease — they watch too much TV news
3 Only George Akerlof knows the answer to this one. Ask him, or his wife.
4 After taxes, $10.38
5 0, because the guy offering me 10 percent has been hauled off to jail. OK… maybe Picard can get my $200 bucks back.

How’d I do?

Aaron May 21, 2014 at 11:37 am

Thank you Jonathan, you’ve made my day

CD May 21, 2014 at 11:54 am

Thanks. This FRB Atlanta study is interesting because it tries to distinguish

- “numerical ability”
- “cognitive ability”
- “financial literacy” in the sense of finance-specific knowledge

a distinction ignored by the OP, most of the discussion here, and well-intentioned calls to teach “financial literacy” in schools.

Lusardi and Mitchell seem aware of this, but on a quick scan of their article, their research does not disaggregate. Am I missing something?

There’s a *lot* of innumeracy out there. Many people don’t understand basic percentages, for example. My guess is that’s a lot of what is being picked up as “financial illiteracy.”

Michael May 21, 2014 at 8:27 am

I have been writing on personal finance for years–some of my pieces get published on very large blogs and receive thousands of comments. It’s interesting, and very sad, reading them. You can divide most of the comments into three groups:

1. The Republicans are evil and at fault for everything.

2. The Democrats are evil and at fault for everything.

3. We’re all doomed.

Personal finance isn’t a particularly emotional topic–it takes a lot of mental acrobatics to relate a statement like “contributing 20% of income into a well-diversified portfolio will provide a very comfortable retirement” into a political statement. But people, particularly Americans, do this all the time.

If we want to educate people about personal finance, we need to get them to think in less political and emotional terms. But I suppose that’s stating the obvious–our economies and nations would run much more smoothly without histrionics and politics, but they’re unavoidable with people.

What’s the solution? I have none. But just saying “we need to educate people” isn’t saying much. You can try to educate them as much as you want, but it doesn’t do much. There are free financial advisors in every ghetto and impoverished rural area in America. They’re still poor. And I’ve yet to see anyone suggest a fix to that problem without devolving into racism, partisan politics, fatalism, or starry-eyed libertarianism/socialism/whateverism.

RG May 21, 2014 at 8:32 am

Probably because the world is a very complex place without easy solutions. I highly doubt there is a one size fits all solution to poverty.

charlie May 21, 2014 at 8:57 am

I can’t think of a single more emotional topic than asking me to take 20% of my income on a bet for the future.

Das May 21, 2014 at 9:23 am

Your imagination seems rather limited…

Jeff May 21, 2014 at 9:56 am

@charlie – I surmise then that you’ve never been married or had kids.

derek May 21, 2014 at 9:45 am

I would suspect that a proposal to teach these things in school, not an option would be an explosive political issue.

Anonymous May 21, 2014 at 10:19 am

“Personal finance isn’t a particularly emotional topic–it takes a lot of mental acrobatics to relate a statement like “contributing 20% of income into a well-diversified portfolio will provide a very comfortable retirement” into a political statement.”

Here are several ways to connect politics with this statement:
1) Democrats/republicans/aliens will destroy the economy so that your investment won’t, in fact, provide any profit.
2) The system shouldn’t allow individuals to become wealthier by just sitting on investments.
3) Can’t contribute to investments because I don’t make enough money for that due to bad politics.

Personal finance advice are generally advice on how to “play the game”, the game being the financial system we have. If you’re of the opinion that the whole game is rigged/unfair/shouldn’t exist in the first place, it is no wonder that personal finance tips sound to you like political discussion.

Brian Donohue May 21, 2014 at 1:02 pm

Bunch of lunatics! Except for group 2, of course.

Marie May 21, 2014 at 2:34 pm

++

Kitty_T May 22, 2014 at 2:20 pm

Sigh. We’re all doomed.

Mitch Berkson May 21, 2014 at 8:33 am

How does guessing inflate the percentage of Americans who answer all three questions correctly?

Ted May 21, 2014 at 9:03 am

Assume that 20% of respondents know the answers to the first two but don’t know the answer to #3 and guess. Half of that 20% will guess correctly and thus the number of people who “know” all three answers will be inflated 10%. Actual inflation will be less, since most guessers will guess on more than one question, but these numbers were picked for clarity.

Aric May 21, 2014 at 8:38 am

My bank charges a $5 monthly fee for a savings account that has less than $300 in it or no recurring deposits. So if I opened a savings account at 2% (right…) and put $100 in it, I could expect it to be empty in less than two years.

If they kept it open and started charging me negative-balance fees, I could expect to be hundreds of dollars in the hole, sent to collections, and sued by the time year five had rolled around.

greg May 21, 2014 at 11:10 am

As a kid, I remember setting up my first account with only $50 and was never charged a dime. My current checking account is free and has a $25 minimum. If you don’t have $300 and have no income whatsoever, the monthly bank fee is the least of your problems.

Benny Lava May 21, 2014 at 8:41 am

Remember when professor Stanley Fish wrote an op ed in the New York Times arguing #2 incorrectly?

http://opinionator.blogs.nytimes.com/2010/11/15/there-is-no-college-cost-crisis/?_php=true&_type=blogs&_r=0

But don’t blame him, he was just citing 2 economists! With tenure and everything!

Jan May 21, 2014 at 3:14 pm

This coming from the guy who Minor Bun Engine made? Laughable.

PD Shaw May 21, 2014 at 9:01 am

The original five question quiz is here: Link

The other two questions are about bonds and mortgages.

Michael May 21, 2014 at 9:21 am

Alabama had more correct answers than New York. Amazing.

8 May 21, 2014 at 10:06 am

Utah might be the highest.

Brandon May 21, 2014 at 10:19 am

Hunstville, Alabama has the highest per-capita rates of engineers and scientists thanks largely to NASA and then subsequent tech investment.

Marcin May 21, 2014 at 10:32 am

The difference is probably not significant.

zbicyclist May 21, 2014 at 10:04 am

I note Alabama had an average of 2.77 correct. New York, a major financial hub, averaged 2.72 correct.

Urso May 21, 2014 at 10:22 am

Obviously the bankers know something we don’t.

greg May 21, 2014 at 11:59 am

The bond question is the hardest, I would say. I knew the answer because I’ve studied the topic, but had I not studied it I don’t know if I would have intuitively known the answer. More of an intermediate topic rather than what I think of as super basic financial literacy.

Anon May 21, 2014 at 1:22 pm

I’ve never studied anything relating to finance or economics (though, strangely, I read this blog a lot), and, indeed, I did not know what the correct answer to the bond question.

On the other hand, 3 struck me as clear and intuitive.

lowcountryjoe May 21, 2014 at 11:00 pm

I think that the bond question is also worded poorly. It’s true the bonds that are available for purchase in the secondary market will increase in price when interest rate rise. But for newly issued debt instruments, it’s quite the opposite, really.

Kathleen May 21, 2014 at 9:23 am

I have always found the 3rd question troubling, because it imbeds a very specific, very statistical definition of “safe”, and the answer assumes that the investor is picking between essentially randomly assigned stocks and mutual funds. Critically, however, that is not what the question actually asks. If you get rid of the unstated assumption that the stock and fund are randomly assigned, the question actually asks this, “Can a person (you) pick a stock that is ‘safer’ than the market?” That is a question that better financially educated people would be more likely to answer the “wrong” way, but which is also more likely to be true the better financially educated the person is. Importantly, even if you used a statistical definition of risk, a low beta, most people who could safely answer that “usually” they could pick a stock that is safer than the market, would “usually” be right. Given that “safe” means “low variance” to statisticians, but non-statisticians would define “safe” very differently, I think the question is worse than poorly phrased, it is essentially deliberately misleading.

cheesetrader May 21, 2014 at 9:25 am

+1

derek May 21, 2014 at 9:48 am

How about expressing the question differently.

Do you believe in the Efficient Market Hypothesis?

Joe Teicher May 21, 2014 at 11:06 am

If it’s a financial literacy test, shouldn’t the question be more like “have you heard of the efficient market hypothesis?”

Kathleen May 21, 2014 at 1:37 pm

The difference between those two questions is exactly my problem with the question. They want to ask if the person understands the value of investment diversification, which is not the same question as “do you define ‘safe’ the way I do?” I think the question gets more noise than signal.

greg May 21, 2014 at 4:57 pm

I think the question is fine. A single stock has diversifiable (idiosyncratic) risk. A portfolio of stocks cushions you from the idiosyncratic risks of any one company. If you have, say, 30 stocks, they aren’t likely to all go bankrupt and that shields you from enormous losses (and reducing the chance for enormous returns).

I think you are confusing beta and volatility. High beta does indeed imply high volatility and risk, but low beta does NOT imply low volatility or low risk. Low beta merely means that returns have low correlation with overall market returns. Gold has high volatility and low beta, for example. I think it is just plain incorrect to take a low beta stock with additional idiosyncratic risk and claim it is “safer” than the market because it has lower beta.

Kathleen May 22, 2014 at 9:03 am

I am well aware of the benefits of diversification. It is not that I disagree with the answer of the question. The basis of my criticism of the question is that I think well-educated, and even financially well-educated, people may read and interpret the question differently than the writer of the question intended.

When an economist says “marginal” it has a very specific meaning, which is only one definition within the set of definitions attributed to the word “marginal” in the broader context of English. I think that “safer” has a similar problem in this context. People who already know the correct answer to this question are all familiar with this very narrow definition of the word “safer”. I think there are better ways of asking this question. Maybe: T or F “ The risk of losing your entire investment is higher if you buy a mutual fund rather than a single company’s stock.”

Tim Ogden May 21, 2014 at 9:47 am

More important than the questions, the idea that financial literacy education (as currently delivered) matters to financial behaviors has little to no evidence to back it up.

Here’s a recent meta-analysis of the financial literacy training literature (covering 168 papers and 201 studies): http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2333898

Bottom Line: “We find that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors…We find tha the partial effects of financial literacy diminish dramatically when one controls for psychological traits that have been omitted in prior research.”

Here’s a (forthcoming in RFS) look at school-based financial literacy programs finding no effect, but a positive effect of basic math skills: http://www.hbs.edu/faculty/Publication%20Files/13-064_c7b52fa0-1242-4420-b9b6-73d32c639826.pdf

Bottom Line: “Can good financial behavior be taught in high school? It can, though not via traditional personal finance courses, which we find have no effect on financial outcomes.

Axa May 21, 2014 at 10:37 am

Ok, it’s not through financial education but good old math. Nice surprise =)

Z May 21, 2014 at 9:49 am

A glance at the list of US presidents since WW2 suggests this is a land of morons. My goodness. We re-elected Clinton, Bush and Obama. That means even knowing they were awful, we thought they were the best we could muster. There’s no positive way to interpret those results.

Willitts May 22, 2014 at 12:39 am

I generally agree with you that in recent times we have elected extraordinarily unremarkable men to the presidency. I think one must look more closely at their opponents in both the general and primary elections to determine whether we suffer from a dearth of good choices or whether the public at large values something different than we might.

McCain and Romney are remarkable men in service and business, respectively. John Kerry and George Bush were practically Mirror, Mirror opposites.

George HW Bush and Dole were also remarkable men with heroic military service and a long history of public service.

Carter and Mondale had good character.

I believe that we have been choosing our presidents since WWII based almost entirely on charisma. Carter and Nixon are the outliers, benefitting from weakened opponents. Is this an artifact of the television age, changing demographics, or a perhaps mistaken epiphany that competence in the big chair doesn’t matter as much as style. I say mistaken because the president’s power comes largely from nominations to offices that affect everyone but few actually ever heard of.

Claudia Sahm May 21, 2014 at 9:53 am

I agree that helping to improve financial literacy is a worthwhile effort for economists. Our value-added is not just explaining a bunch of financial terms, but trying to figure out what are the missing pieces for good decision making. (For example, few need to know how derivatives work, but compounding and opportunity costs are helpful concepts for almost everyone.) There are still a lot of open questions and much debate about how much can be taught versus how much financial products should change. On this research process I have enjoyed the seminar series that Professor Lusardi runs http://business.gwu.edu/flss/ As one example, here is her presentation of their study on financial literacy around the world: http://business.gwu.edu/flss/program/spring-2012-3/

dearieme May 21, 2014 at 10:00 am

Drafting a good questionnaire is much harder than most people suppose. Getting an American to draft one that will survive translation – even if only into other varieties of English – really is asking a lot.

Willitts May 22, 2014 at 12:43 am

Absolutely correct. I wonder though if the answers are affected more by faith in local institutions than comprehension, translation, or literacy.

With sufficiently high fees or chance of theft, any fund can be far riskier than a single stock.

8 May 21, 2014 at 10:10 am

The first two questions should be part of a voting test.

prior_approval May 21, 2014 at 10:18 am

‘I agree that helping to improve financial literacy is a worthwhile effort for economists’ to stay away from as far as possible.

Seriously, accountants would be the proper profession to explain how bookkeeping and finances works.

Though to be fair, there is one group of people even less suited than economists to advise people in this area, and that is law professors. Especially ones like Prof. Zywicki ( http://mason.gmu.edu/~tzywick2/ ), who can be counted on to defend the right of people to pay 300% interest – ‘Payday loans—short-term unsecured loans intended to be repaid upon the receipt of expected income within a pay period—may legitimately be the most attractive option, due to their convenience, reliability, and availability on short notice. Most payday loan customers do not have credit cards or would exceed their allowable credit limits if they used credit cards. Payday loans therefore fill an important gap in the supply of financial services to the poor. These loans do have high effective interest rates, but research shows those high prices can be explained by the high costs of originating and servicing many small loans and their high risk of default.’ http://mercatus.org/publication/pitfalls-regulating-consumer-credit

That’s right – GMU financial advice at its finest. An explanation of what that means can be found here – http://consumerist.com/2013/01/16/professor-tries-fails-to-defend-payday-lending-as-legitimate-form-of-credit/

dan1111 May 21, 2014 at 10:51 am

That sounds like a logical argument to me. It is not self-refuting, as you seem to believe it is.

prior_approval May 21, 2014 at 11:16 am

Well, if you think anyone paying a 300% APR for a loan is sound financial advice, you may just want to talk to the general director of the Mercatus Center.

And if you can believe it, the federal government actually forbids a group of people being able to take advantage of that low, low APR of 300%.

‘It is not self-refuting’

Usury is not self-refuting – and why anyone would think it is escapes me. Usury is profitable, after all. As long as one is the money lender, of course. And one has access to a large pool of people desperate to take advantage of the bargain of taking a dollar to pay four back.

dan1111 May 21, 2014 at 11:45 am

The cost of the loan is expressed in terms of “300% APR” for shock value, but payday loans are intended as short term loans. If you pay a $6 fee to borrow $100 for one week to cover an emergency expense, is that obviously extortionate?

The fact that payday loans are banned to military members (and illegal in some states) is simply question begging. It doesn’t actually prove that the loans are bad, only that some people think they are bad (I knew that already).

Basically, here is how I come out on this:

1) A good case can be made that payday loans are actually a beneficial product when used for short-term, emergency purposes.

2) Some people obviously end up in long-term debt through such loans, and this harms them greatly.

3) Whether these loans are beneficial to society depends on the balance between #1 and #2, as well as what alternatives the people in each use case have. Advocates for banning the loans are never interested in this discussion.

4) The loans should be allowed for freedom of contract reasons, whether or not they are beneficial.

prior_approval May 21, 2014 at 12:42 pm

‘If you pay a $6 fee to borrow $100 for one week to cover an emergency expense, is that obviously extortionate?’

Yes – but then, I live in Germany, surrounded by people who would agree with that. Along with apparently having more financial literacy than Americans.

‘The fact that payday loans are banned to military members (and illegal in some states) is simply question begging.’

Or the fact that an organization which prefers to exploits its members all by itself is uninterested in any competition from the private sector. Is that cynical enough to pass muster?

‘The loans should be allowed for freedom of contract reasons, whether or not they are beneficial.’

As previously noted, you really need to talk to the general director of the Mercatus Center – they at least find such arguments convincing. A couple of German expressions that cover the idea that paying 6 dollars to borrow a 100 dollars for a week makes sense include ‘Milchmädchenrechnung’ and ‘Bauernfang.’

dan1111 May 21, 2014 at 1:24 pm

@p_a, what if a short-term loan allows you to fix your car, so you can get to work and don’t get fired? Or it allows you to pay your electricity bill (avoiding a very large fee that is incurred when your electricity has been turned off and you have to get it turned on again)? For those without any savings and limited borrowing options, there are many cases in which a short-term loan has more benefit than the cost in fees.

JWatts May 21, 2014 at 4:35 pm

If you pay a $24 fee on $100 for one month to cover the additional electricity expense associated with energiewende, is that obviously extortionate?

TMC May 21, 2014 at 6:26 pm

+ Jwatts

It’s not extortion if the gov’t does it.

Dan Weber May 22, 2014 at 12:21 pm

Has any charitable organization tried to set up their own payday loan business? The primary idea would be that everyone who walks through their door is in need of a direct financial intervention. And whatever the gouging that the existing businesses are doing, they could undercut it, letting the community keep more of their money.

(That last sentence assumes that payday loans are highly profitable, which I doubt, but the charity wouldn’t realize it until they are already at work.)

Cliff May 21, 2014 at 12:09 pm

300% is completely reasonable for a short term loan. In the gambling world, people often lend their friends significant sums of cash for short periods of time, and the interest rate is invariably something like that- and this is among friends where both are very happy with the arrangement. And there is a (probably much) lower default rate as well.

Willitts May 22, 2014 at 12:50 am

Since the customers CHOOSE from available options, their preferences are revealed.

No one I know would be better served by payday lenders or their supermarket, but lots of low income people are not served by banks. Their fees can end up just as high as payday loans.

And what privilege do you have to say that 300% interest is too high, especially if that represents the actual risk faced by payday lenders? Regulate them to a lower rate and they might disappear to the detriment of customers.

It is precisely your thinking that entrenches and sanitizes poverty.

Urso May 21, 2014 at 10:21 am

The correct answer to all three is “needs more information.”

Dude May 21, 2014 at 10:39 am

There is some evidence (sorry, not enough time to find the study) that taking financial literacy class is counter productive b/c it helps people think they are more knowledgeable than they actually are. Those who haven’t taken a class are more likely to seek out expert advice than those who have take a class.

At least that’s what I remember from the study.

ummm May 21, 2014 at 10:39 am

financial literacy doesn’t work for many during the recession. many ppl who were financially literate lost tons of money and never recovered because they picked bad investment even though they were literate. the safest place to keep money is in cash or in the S&P 500 if you don’t sell it. penny wise pound foolish

Sean P. May 21, 2014 at 11:29 am

Let’s be honest here. For most people who have no real financial literacy, this would be the expert-level quiz. This is how many people view financial literacy:

You spend 100% of your income every month. Is this a good thing?
1. Yes, because I deserve this lifestyle.
2. Yes, because I can just put everything on my Visa card if I run out of money this month.
3. Yes, because the economy’s going to tank next year anyway so there’s no point in saving money

What is the best thing to do with your savings?
1. Hide cash under the mattress, because that way those crooks at the bank can’t touch it.
2. Invest it all in gold, Florida real estate and Groupon stock, because my buddy told me that those are the best investments.
3. Buy a boat, hot tub, vacation home, etc. What could ever go wrong?

You have maxed out your credit card. What now?
1. Get a new one.

Willitts May 22, 2014 at 12:59 am

LOL, very well put.

The point seems to be that we are not interested in literacy, per se, but sound financial planning from the perspective of a better than average income earner, and to overcome emotional biases and misinformation.

The part about stuffing your mattress is funny because no insured depositer has lost a dime in a bank failure since the inception of the FDIC. Some uninsured deposits were lost, but those depositors are hardly typical.

If literacy is a problem, it might be lack of knowledge of alternatives or being intimidated by processes such as taking out a mortgage.

Sir Barken Hyena May 21, 2014 at 11:38 am

This is another reflection of the technocratic state’s insistence that we all be above average. If you aren’t now, well take some classes you dummy it’s your own fault, average is over, didn’t you hear?

Jimbino May 21, 2014 at 12:07 pm

“Safer” in the last question is ambiguous at best. The “safest” is to put cash in the safe deposit box. Less safe, but with a better expected return is to put it in a mutual fund. Least safe, but with the best expected return is the single company stock.

I find it amusing that folks who praise diversification usually are those married to one woman.

greg May 21, 2014 at 5:26 pm

A single stock generally will not have a higher expected return than a mutual fund. With single stocks, you are bearing uncompensated risk.

Jimbino May 21, 2014 at 11:55 pm

That would be hard to establish, considering the plethora of investment possibilities. What you can say for sure is that investing in one of the S&P 500 will on average turn out better than investing in an S&P 500 index fund, almost by definition, once you consider fees.

Anonym May 21, 2014 at 12:19 pm

1)
Savings accounts? Your thinking is a generation or two gone by. I put $50 in a saving account when I was 10 and the regional bank paid 2.5%/year. I was aware that this ‘magic of compound interest’ BS seemed like a scam *then* – how can 2.5% add up to anything significant? By the time I was 15, the rates had gone down to 0.2%. By the time I was 20, the bank (following not one but three mergers) was actually charging a service fee of $5/month, which quickly drained the account.

For the last generation, the only function of a conventional savings account has been to encourage people to split their money into two stacks, so that it’s easier to incur overdraft fees on the one stack they’re allowed to spend on things.
2)
We have gone to great pains to produce a zero-inflation anchor currency. If people forget what inflation means, isn’t that success?

3)
Aside from the wording: Half of American families live paycheck to paycheck. Another 40% have some liquid savings outside their home, but not enough that interest is ever going to pay for the effort of learning about finance – it’s just funds for major purchases like college, a house, a car, an appendectomy, or a nursing home. These questions are not relevant for most of us at all. Ask about credit cards, about payday loans, about car payments or mortgage refinancing or student loans & psychology degrees.

dan1111 May 21, 2014 at 1:35 pm

1) This is a very simple question about interest rates. Even if savings account interest is now trivial, most people still deal with interest rates in everyday life–credit cards, mortgages, car loans, etc. An inability to answer this question should be worrying.

2) U.S. annual inflation was 2% or higher in 7 of the last 10 years (according to CPI). What is this zero-inflation currency you are talking about?

3) Anyone with a self-directed retirement account like an IRA has the opportunity to make this kind of choice. And this is a lot of people. Over half of American adults own stock–and a higher proportion than that are going to own it at some point in their lives. Many people living from paycheck to paycheck now will accumulate savings as they get closer to retirement.

Willitts May 22, 2014 at 1:08 am

My banks use savings accounts as overdraft protection. Is this not a common practice?

For low income people, if they find themselves overdrafting it is a simple matter to close their savings account if they even have one at all.

Your statement about the motivation to encourage savings is hysterical. Banks prefer savings accounts because their balances are more stable and their cost of servicing the account is cheaper than checking. This is irrespective of fees. Savings describes the behavior of the account.

Chris May 21, 2014 at 1:28 pm

Financial literacy is very important, and schools need to teach it. The problem is that most teachers are just as clueless as their students, and thus don’t know what to teach. They certainly would not be comfortable with the source material. But you have to start somewhere.

The problem is one of familiarity. Stocks, bonds, different investment sectors, and portfolio management are exotic, strange, mysterious terms if one has never been exposed to them. Until the creation of age based mutual funds for requirements, I saw many people look worried and confused at the company’s 401(k) meetings so they did the same thing – divide up their contirbutions equally among all funds. None of them were dumb people – but this was all new to them, and it was overwhelming to make a decision about something they did not know anything about.

Fortunately, the basic things about financial literacy are fairly easy. Frustrated I was not taught anything in school, I did a lot of reading in my twenties. 90% of all books say the same thing, but in different words. Take the average book by Suze Orman, Dave Ramsay, the Wealthy Barber, and many others and it’ll be an appropriate text. The other 10% is for more sophisticated investors (and sometimes of dubious value) that students can easily understand once they mastered the basic books.

The first step is just exposure to terms, understanding the relationship between risk and reward, basic portfolio theory, a history of bubbles and why people lost money in them, and the importance of self discipline and paying yourself first. The second step is to go over the most likely financial decisions anyone would need to make during the lifetime – how much life insurance to buy (and when), financing a car and home, what people do to get you to part with their money so you can avoid scams, and basic retirement planning. That’ll cover 90% of what people need, and they’ll be much more confidant dealing with those issues.

lxm May 21, 2014 at 5:10 pm

yes, yes!

Robert May 21, 2014 at 1:38 pm

If I had $100 in a BofA savings account, they would charge me $20/month for not having a minimum balance. in 5 years I would owe them a fortune.

Willitts May 22, 2014 at 1:13 am

In five months neither of you would owe the other anything. But it probably wouldn’t take you five months to figure out that a savings account isn’t right for you, and you wouldnt need financial literacy for this epiphany.

Banks offer higher interest on savings accounts in exchange for stability of balances. You seem to be advancing the notion that banks are stealing.

Li Zhi May 21, 2014 at 6:05 pm

1. Lets see 100*(1.02)^5 = more than 102 but I also don’t know exactly (especially if bank has fees) so should I pick the last correct answer (I don’t know) or “THE” correct answer?
2. Hmm. Maybe its a trick question and I just need to show that I’m sophisticated enough to know that there IS no single “inflation rate”. Given that I now have to buy Health Care coverage, and didn’t last year, there aren’t a whole lot of scenarioes where “Less” isn’t the right answer…
3. Well, if I make highly aggressive mutual fund purchases, but only buy utility stocks, then obviously stocks are safer.

rob42 May 21, 2014 at 9:06 pm

4/5 I’m right at the Alabama average. :(

Not that I didn’t know the answer, but I was clicking through too quickly and inadvertantly clicked on the wrong answer (or so I tell myself).

Willitts May 22, 2014 at 1:20 am

Lots of good comments on this thread, including the bad ones.

The interesting thing to me is how long does it take for the financially illiterate to realize their answer is wrong. People bring up fees. Well, it doesn’t take more than a month to realize you lost money and a few months to realize this will remain a losing proposition.

Same with a single stock.

What is the fuss over ignorance that is self correcting?

Dan Weber May 22, 2014 at 12:29 pm

Sometimes it’s hard to pay attention to important things when everything else in life is spinning at a million miles an hour. I didn’t grok this at all when I was young and single, when I could precisely control how much complexity was in my life. Now that I’m married with kids, there are so many things to keep track of that I deliberately pay money to avoid having my concentration pulled away.

Jon May 22, 2014 at 2:41 am

Hey! I built that site! Awesome to see it mentioned in one of my favorite blogs!

buddyglass May 22, 2014 at 10:52 am

Utah seems to have the highest average among U.S. states. At least, that’s what I got from just selecting different states in the drop-down menu after completing the 5-question version of the test.

btw- could someone who has access to the journal article post the 3-question percentages for some countries besides Germany, Switzerland, New Zealand, Russia and the U.S.?

buddyglass May 22, 2014 at 10:58 am

Nevermind. Thanks google!

http://arno.uvt.nl/show.cgi?fid=129675

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