Financial Literacy: State of the Union in 2013

April is financial literacy month.  I believe that lack of financial knowledge is one of the most critical problems that our country faces.

It is well understood that someone who is illiterate in the traditional sense (reading, writing) is severely handicapped in terms of work and opportunities available to them.  The person who cannot read or write is likely to be taken advantage of at every turn.  He will miss opportunities for improving his life as well, because the ways that we find new opportunities and avoid choosing the wrong paths often come in the form of text.  It goes without saying that not being able to read and write essentially guarantees that you will be poor.

I believe that being financially illiterate is almost as bad as being illiterate in the traditional sense.  People who are financially illiterate have almost no chance of financial stability, much less success.  Financial illiteracy also poses huge problems for society.  People who don’t understand the importance of saving, for example, are far more likely to end up on the public dole.  People who take on massive levels of expensive and unsupportable college debt pose a problem for society as a whole.

Financial literacy is having the knowledge and know-how to understand and function in a modern financial system.  Obviously this entails basic math skills, but there is far more involved.  To function in a modern society, people need to understand how to (1) manage a bank account, (2) manage and pay taxes, (3) determine how much debt they can reasonably assume, (4) determine how much they need to save, and (5) choose how to invest these savings.  These five categories are the absolute minimum and of course there are different levels of sophistication required in each, but particularly in number five.

The State of Financial Literacy

A 2012 study by the SEC concluded that the level of financial literacy in the U.S. is dangerously low.  The SEC’s report concludes that

“studies show consistently that American investors lack basic financial literacy. For example, studies have found that investors do not understand the most elementary financial concepts, such as compound interest and inflation. Studies have also found that many investors do not understand other key financial concepts, such as diversification or the differences between stocks and bonds, and are not fully aware of investment costs and their impact on investment returns. Moreover, based on studies cited in the Library of Congress Report, investors lack critical knowledge about investment fraud.”

The problem is massive and widespread.  I have had many conversations with many people who are well-educated in the traditional sense who are largely financially illiterate in terms of being able to make decisions about their financial lives that would be considered reasonable by most financial professionals.  Studies of financial literacy confirm that even wealthy and well-educated people lack financial literacy.  Many people are unaware of (1) how much they pay in expenses to their various providers of investment services, and (2) whether the people giving them advice are legally required to give them advice that is in their best interests (e.g. have fiduciary responsibility).

A 2012 survey found that the majority of participants in 401(k) plans did not understand the fees that they were paying.  Related research finds that investors do not properly take mutual fund fees into account when choosing a fund.  Nobel Laureate Bill Sharpe has a new paper that shows that bad choices among mutual funds can reduce your lifetime wealth accumulation by 30%.  A variety of other calculations come up with consistent results.

The largest of all financial literacy issues revolves around savings.  The data consistently show that people have little idea of how much they need to save and save far less than they need to.

The Future

A generation or two ago, the average American worker or retiree did not need to worry so much about financial literacy.  If you had useful skills and could hold down a job, your employer took care of health insurance and a pension in retirement.  Employers determined how much they needed to take out of each paycheck to provide for retirement, and promised to provide for lifetime income in retirement.  Today, with the shift from traditional pensions to self-directed plans (e.g. 401(k) plans) and shorter tenure with employers, individuals shoulder the responsibility for making the most crucial financial decisions in their lives, such as how much to save and how to invest these savings.  We have also seen shifts in levels of individual debt.  As college costs have risen far faster than inflation, more people take on substantial levels of debt to pay for education before they ever enter the workforce.

An excellent survey of the state of financial literacy and the effectiveness of financial education concludes that there is very limited evidence that financial education programs to date have been effective at actually raising levels of financial literacy.  For this reason, it is unclear that we, as a nation, know how to proceed.  Given our current situation, the best that we can hope for is increased awareness and focus on the problem of financial literacy.

In practical terms, on an individual basis, there is a great deal that people can accomplish even if large-scale programs appear marginally effective.  There are a number of very good books that are invaluable in educating yourself.  I recommend starting with Your Money Ratios by Charles Farrell and The Bogleheads Guide to Retirement Planning by Taylor Larimore et al.  For younger readers, I suggest Debt-Free U by Zac Bissonette and I Will Teach You to Be Rich by Ramit Sethi.

Related Links:

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

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