Understanding basic concepts can spell the difference between personal financial stability and wealth on the one hand, and perpetual financial difficulties and stress on the other.
Increasing the level of understanding of basic financial ideas and concepts could improve a number of pressing social problems such as excessive student debt and mortgage foreclosures, income inequality, poverty in retirement, and more.
I’m not talking about complicated investment strategies, chief-financial-officer-level corporate maneuvers, or CPA-type vocabulary (though those skills can certainly be helpful in achieving financial goals). Rather, I’m referring to the basic information an individual would need for everyday decisions about money and spending such as renting or buying a house, taking out a loan, or saving for retirement.
You may have seen a three-question test of financial literacy developed by two professors—Olivia S. Mitchell of the University of Pennsylvania’s Wharton School and Annamaria Lusardi of the George Washington University School of Business. (A quick internet search on “three question financial literacy quiz” will pull up a copy if you’d like to take it yourself.) The questions deal with compound interest, the relationship between interest and inflation, and very basic portfolio diversity (whether or not a single company stock usually provides a safer return than a mutual fund).
These are things we all need to understand to optimize our financial situations. Without a concept of compound interest and how it can work for you (in the case of an investment) or against you (in the case of some types of debt), individuals are more likely to save less and borrow more than they ideally should. It is also important to understand that when inflation is higher than interest on a savings account, purchasing power is being lost over time. The point that mutual funds are generally a safer way to earn a return than one company’s stock is critical to ensuring that an appropriate investment strategy is followed.
Here is the bad news: only about one-third of Americans over 50 can answer these questions correctly. Of those with a college degree, 44 percent answered all three correctly; it was 31 percent for people with some college. The linkages between educational attainment and earnings are well established. The fact that people with less education tend to also not understand financial concepts exacerbates the problem, leaving them even more vulnerable to money woes. In fact, some pundits are pointing to a lack of financial literacy as a key factor in growing income inequality.
The Organisation for Economic Co-operation and Development (OECD) includes financial literacy questions as part of its Programme for International Student Assessment (PISA), an international survey evaluating education systems worldwide by testing the skills and knowledge of 15-year-old students. Students in the United States fell below the average, behind Shanghai-China (which topped the list by a big margin), the Flemish Community (Belgium), Estonia, Australia, New Zealand, Czech Republic, Poland, and Latvia. We also had a large relative share of students performing at the lowest level. Fewer than five percent of American students fell into the top performance category, compared to almost 43 percent of those in Shanghai-China.
Direct banking and payment services company Discover Financial Services surveyed high school seniors through its Pathway to Financial Success series. Personal finance and money management was ranked as the most critical skill for personal future success (tied with math and above science and technology), with 82 percent of seniors recognizing the importance of managing finances. However, only about one-third indicated that they feel very confident in their abilities in this area, and another one-third said they had already had problems.
The 2015 Consumer Financial Literacy Survey prepared by Harris Poll for The National Foundation for Credit Counseling indicates that just over half (52 percent) of those surveyed were very confident they made the right choice the last time they made a major financial decision, with another 40 percent were somewhat confident. Almost 30 percent are saving nothing for retirement, and 33 percent carry credit card debt from month to month. Relatively few indicated they have savings in investments/mutual funds (30 percent), 401k plans (29 percent), or IRAs (25 percent). These findings further support the idea that individual financial decisions are contributing to differences in the rates of wealth accumulation among Americans.
Education can make a difference. The National Endowment for Financial Education sponsored a study of the issues a few years ago. Study authors (Michael S. Gutter, Zeynep Copur, and Selena Garrison) looked at data from almost 16,000 college students and found that those from states where a financial education course was required had the highest reported financial knowledge; moreover, they were more likely to display positive financial behaviors such as saving more, acting responsibly with credit cards, and avoiding compulsive buying. They were found to be more willing to take average financial risk, which is an important aspect of investing.
Texas has higher requirements for economic and financial education in public schools than some areas. Only 24 states require high schools to offer economics classes, and only 19 require offering of a personal finance course. (Texas has long required students to economics classes that include financial literacy topics.) Over time, getting young people off to a good start will improve the situation; the better these courses and teachers do their jobs, the more prosperous the future populace. For those of us past the K-12 years, there are resources online, in libraries, and elsewhere to enhance financial literacy. As parents, we should begin teaching money concepts early and often. It can only help!!