Get smart

Posted by on July 18, 2013 @ 2:15 pm in Personal finance

Please tell me whether this statement is true. Buying a single company’s stock usually provides a safer return than a stock mutual fund.

a) True.
b) False.
c) Don’t know.
d) Refuse to answer.

The answer, of course, is b. In the National Financial Capability Survey (NFCS), sponsored by FINRA and the U.S. Department of the Treasury, only about 52% of Americans answered this question correctly.

In “Optimal Financial Literacy and Saving for Retirement,”¹ Annamaria Lusardi, Pierre-Carl Michaud, and Olivia S. Mitchell look beyond the reliably grim big picture to put a price tag on our ignorance.

Education, financial literacy, and retirement assets

The researchers used results from the NFCS and heavy-duty econometric techniques to estimate assets at retirement for three groups of savers: those without a high school diploma, high school graduates, and college graduates.

Not surprisingly, those with more education tend to be more financially literate, as measured by the percentage of correct answers to the NFCS. Those with higher financial literacy scores tend to make greater use of “sophisticated” investment services such as IRAs and stock mutual funds, which is the researchers’ key to enhancing long-term wealth accumulation.

Education level Percentage of correct answers on NFCS Use of sophisticated investment products and services (%)
No high school diploma 44.1 39.6
High school diploma 56.7 51.7
College diploma or greater 80.6 80.4

Source: Lusardi, Michaud, and Mitchell (2011).

What if we could acquire perfect financial literacy at no cost? What if all of us scored 5 out of 5 on the NFCS questions about interest rates, inflation, bond returns, compounding, and diversification? The benefits would be greatest for those with the lowest financial literacy scores, as their newfound knowledge would allow them to make greater use of sophisticated and higher-returning investment services.

In a world of perfect financial literacy, those without a high school diploma could increase their wealth at retirement by about 18%, without any changes in their earned incomes or savings rates. For college graduates, perfect financial literacy would boost wealth at age 65 by 4.5%.

Education Level Assets at age 65 based on current levels of literacy Assets at age 65 based on perfect financial literacy Percentage change
No high school diploma $153,855 $181,360 +17.9
High school diploma $211,054 $241,241 +14.3
College diploma or greater $395,864 $413,742 +4.5

Source: Lusardi, Michaud, and Mitchell (2011).

What keeps us from getting smart? Here’s where things get complicated. There’s a cost to increasing our financial literacy, whether in the form of fees paid to an advisor or in the opportunity cost of time spent reading books or using websites.

Higher-income savers have strong incentives to pay these costs, in part because Social Security replaces a relatively small percentage of their earnings. If they want to maintain a stable level of consumption throughout their working and retired years, these savers need to get smart. For low-income savers, the cost of acquiring financial knowledge may outweigh the benefit, and modest levels of financial literacy may be “optimal.”

Another explanation for low financial literacy is that financial services are complex. It’s too hard to get smart about compound interest and adjustable-rate mortgages. Economist Robert Shiller, who lays some of the blame for the 2008–2009 financial crisis on our poor grasp of financial concepts, has suggested that one response to poor literacy might be government subsidies for financial advice.²

Fixes in the works

I wouldn’t count on a grand policy initiative to raise financial literacy across the board. Instead, we’ll probably continue to tackle the challenge on a number of fronts, and here there’s promising news.

As my colleague Steve Utkus has written, the evolution of the 401(k) plan has, in effect, reduced the cost of acquiring financial knowledge. At the end of 2012, 32% of Vanguard-administered retirement plans automatically enrolled new employees in the plan, double the 2007 level. The default investment selection in almost all of these plans is a balanced investment strategy that allows retirement savers to diversify widely across the stock and bond markets.³

Increasingly, workplace retirement plans are automating the kinds of financially productive behaviors associated with higher levels of financial literacy. Knowledge is good, but its absence may no longer be as costly.

At the grassroots level, we hear promising anecdotal feedback about Vanguard volunteer initiatives such as My Classroom Economy, a program that makes high-quality financial education resources available to teachers across the country. Just as the internet has reduced the cost of distributing these materials, it may yet bring down the cost of providing high-quality investment advice to larger and less affluent groups of savers.

The bookstore and the library card

Finally, there’s the library card. When I first enrolled in a 401(k) plan, I probably would have scored no better than 40% on the NFCS. Interest rates? Sure, I knew what those were. Inflation? Yes, I’d done time in the 1970s. Compounding? Diversification? Not really.

My plan provided me with good basic educational material, but it was a tricky leap from the brochures to investment selection. I signed up for a hodgepodge of investments. Months later, I wandered into the investing section of a bookstore on the North Side of Chicago. In an inspired, if ambitious, act, I pulled Bogle on Mutual Funds from a stack on the new book table. After all, my 401(k) plan had mutual funds.

I won’t say it was an easy read for the financial novice. The prose harkened back to the 19th century, with casual references to the Roman poet Horace. The lessons unfolded across charts and tables with an uncompromising mathematical logic. This wasn’t a “how-to.” This was a Ph.D. in mutual funds packed between hard covers.

But the book made abstract concepts such as diversification concrete. It explained the role of stocks and bonds. It included model portfolios. Above all, Bogle on Mutual Funds taught me about the importance of investment costs. I was set for life.
 
 
 
¹Lusardi, Annamaria, Pierre-Carl Michaud, and Olivia S. Mitchell, 2011. Optimal Financial Literacy and Saving for Retirement, Pension Research Council Working Paper WP2011–20, Philadelphia: Pension Research Council.

²”How About a Stimulus for Financial Advice?” by Robert J. Shilller, January 17, 2009; available at http://www.nytimes.com/2009/01/18/business/economy/18view.html?_r=0

³ Utkus, Stephen P., Jean A. Young, 2013. How America Saves 2012. Valley Forge, PA.: The Vanguard Group.

Follow

Get every new post delivered to your Inbox.

Join 227 other followers