A recent WSJ blog post covered the work that professors from University of Pennsylvania’s Wharton School and George Washington University School of Business are doing on financial literacy. Their research is based on just three basic questions, and what they’ve found is eye-opening. But before we get to their findings, here are the questions (the answers are at the bottom of this blog post). Can you do better than 2/3rd’s of the US population? Good luck!
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?
a. More than $102
b. Exactly $102
c. Less than $102
2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
a. More than today
b. The same as today
c. Less than today
3) True or False: Buying a single company’s stock usually provides a safer return than a stock mutual fund.
So, how’d you do? (Answers at the bottom). If you answered all three correctly, count yourself as lucky. And tweet us @JellyvsionAlex using the hashtag #financiallyliterate. We’ll send you something fun!
Lack of financial literacy is not just a US problem, and not just a problem of the under-educated.
The professors found that lack of financial literacy is rampant, not just in the US but also in other relatively rich countries such as Germany, the Netherlands, Switzerland, Sweden, Italy, France, Australia and New Zealand. And even though the better educated in all of these countries are more likely to answer all three questions correctly, only 70% of the most highly educated cohort in all countries get all the answers right.
Why does this matter?
As you may expect, the professors found that being financially literate is strongly correlated with being a better planner, saving money (and interestingly saving time) and accumulating wealth. Financially literate people know when to refinance their mortgages to save money, they don’t borrow against their 401k, they’re more likely to invest in more sophisticated asset types (therefore generating higher returns without increasing systematic risk) and they are less likely to use high cost borrowing methods like payday lending. They are in control of their spending and saving, and therefore they enable themselves to be fully functioning adults. When people make bad financial decisions, these decisions eventually have a negative impact on their families, their work productivity and their stress levels.
Being financially literate is particularly important for younger people, as they are entering the work force with more debt (especially student loan debt), and they’re being asked to make more decisions about debt, retirement planning and healthcare insurance than their parents. Unfortunately, recent testing of Millennials shows similar poor financial literacy results when compared to older adults.
Finally, the report’s authors also point out that an astounding one-third of the US wealth inequality could be accounted for just based on the differences in financial knowledge between people.
Is financial illiteracy an unsolvable problem?
Fortunately, we’re all not doomed to a life of financial illiteracy. The professors found that correctly answering just one additional question from the three listed above is correlated with a 3 – 4% increase in greater probability for planning for retirement.
To improve financial wellness, the report highlights two initiatives that look to be successful: financial education in school and in the workplace. A 2010 study of financial education in high school worked to improve financial literacy, and this was later backed up by work that was done in several European countries. Furthermore, a program that was launched for employees called ‘Five Steps’ that focused on teaching five core concepts of financial planning for retirement showed that attendees retained between one quarter and one third of the program’s knowledge. In this case, the Five Steps program used short (3 minute) narratives to deliver the information.
ALEX on: Financial Wellness is coming this summer – sign up for sneak peek now!
Financial illiteracy is a big problem that will continue to mushroom, especially as more and more people are asked to make more decisions about increasingly complex topics.
To help tackle this problem, we here at ALEX will be launching a new product focused on helping people make better financial choices and on getting them on the path to financial wellness.
(Answers: a., c., false)