Monday, February 25, 2013

A KISS for Financial Education

Common sense trumps mathematical sophistication

The WALL STREET JOURNAL had a piece entitled “Tackling Investor Ignorance” on November 3, 2012.  It was an interesting effort to try to point out a major financial problem.  They deserve to be congratulated for addressing the issue.  As they stated: “The financial crisis exposed greed, reckless decisions and regulatory failures. Now we can add another shortcoming to the list: the ignorance of too many small investors.”  It's about time someone pointed that out.  But it isn't just small investors: it's actually consumers in general. 

To me it seems obvious from the start.  You can’t have a financial crisis like we had if only one side participates.  It took all players, which seems fairly obvious given that the problems were system wide.

It is interesting that among the key things the article points out is a need for a broader understanding of budgeting.  Two years ago this blog pointed out the crucial role of budgeting.  Specifically, in a posting entitled “Investing Part 3: Setting thevolume,” it noted a scene in the movie “It's a Wonderful Life” where George avoids the clutches of the evil banker, Mr. Potter, due to the astute financial management of Miss Davis who only withdraws $17.50 rather than the $20 withdrawals of the customers before her. She knew she could get by for $2.50 less than the previous customers. That she leaves that $2.50 in the Bailey Building and Loan is crucial. George squeaks by with $2 left at the end of the day.  Ms. Davis’s ability to budget with such accuracy saves Bailey Building and Loan.
Budgeting is the starting point.  It is essential to financial management.  It is troubling that the origin of some of the research that “discovered” the deficiency in consumer’s financial management is a Securities and Exchange Commission multipart report, ordered up by the Dodd-Frank financial-overhaul law.  Why in the world did the Security and Exchange Commission need a study to figure out that people who took out loans they could not pay back did not understand financial management?  Talk about government waste! 

Far too many people believe that good financial management means simply figuring out how to spend more.  They do not have even the most rudimentary understanding of the role of budgeting in financial management.  Only the government would need a study to figure that out.  How could it be made more obvious?  All the government would have to do is examine their own behavior.

The article goes on to discuss some of the issues raised by the public's lack of understanding of basic financial management.  However, the article makes the issue sound far more complicated than it is.  That can be seen in the passage below:

“Still, people can't be experts about every financial product or investment. So what exactly do they need to know to make good decisions?”

“Plenty of experts have been wrestling with this. The nonprofit Council for Economic Education is working on standards for students in fourth, eighth and 12th grades in six main subject areas: earning income, buying goods and services, saving, using credit, investing and protecting and insuring assets.”

All of the items listed are important, and all, at one time or another, have been the topic of the discussion in this blog.  However, as has been pointed out on this blog, starting with the basics eliminates much of the complexity.  No one is an expert in every financial product or investment, but they do not need to be.  It is irrelevant to good financial management.

As the WALL STREET JOURNAL article goes on to note, “Mortgages and life insurance just aren't relevant to a 17-year-old.  Instead, both young and old need to understand broad concepts that can be applied to their current financial needs as well as those that might come along tomorrow.”  Much of the supposed complexity of raising the public's understanding of finance originates from overlooking the simple fact that there are not that many “broad concepts that can be applied to their current financial needs as well as those that might come along tomorrow.”

On July 10, 2011 a posting entitled “The Only Truth About Finance” discussed a fairly simple concept that trips up many people.  Many people who are broke are broke because they do not accept the inevitability of ending up broke if one always spends everything one can spend.  People spend inordinate amounts of time looking for other reasons why they are broke.  Their income is too low, they were cheated, something unexpected always comes up, or any number of alternatives excuses.  The idea that being broke is the result of a ratio between two variables (income and expenditures) never occurs to them.

As should be clear from the posting on investing that used “It's a Wonderful Life” as is point of departure (“Investing Part 3: Setting the volume”), the inability to budget is a recent phenomenon.  In “It's a Wonderful Life” the fact that all of George's customers can budget is an assumption made without fanfare.  It's just the way people lived.

The financial crisis that we just experienced revealed the problem is far more serious than people just spending everything they have.  The problem was that many people spent much more than they had and committed to continue the behavior by borrowing money they could not pay back.  The July 21, 2011 posting entitled “Truth In Lending” and July 25, 2011 posting entitled “Borrowing For Investment” contain some of the most important lessons on financial management. 

Those postings make quite clear is that there is only one way borrowing can be in the interest of the borrower.  If having whatever is bought for that period of time between when it is bought and when the individual could have saved the purchase price is greater than the additional cost that borrowing implies, then the cost of borrowing can be justified. But it is only justified if the borrower’s income does not go down during that period of time.  In the US borrowing seldom results in a person being better off.

It is no wonder that for many years the definition of a middle class lifestyle involved having no debt other than a mortgage.  A home is one of the few consumer items that meets the criteria that justify taking on debt.  The default assumption was that borrowing would only make it less likely for the person be able to achieve middle-class.  That's still the case, but now people don't seem to realize it or are unwilling to accept it.

Our current approach to truth in lending really should be referred to as truth in borrowing.  We seem more intent upon making it possible for people to borrow rather than to educate them about the risks associated with borrowing.  That is unfortunate because nothing is more destructive of prosperity, both for the individual and for society, than the US public's attitude toward borrowing.  It is a system-wide problem. 

Annamaria Lusardi, professor of economics and accountancy at George Washington University, has developed a number of ways to measure financial literacy.  Some of them have been referenced in previous postings.  She and numerous other people collecting data on the topic have focused on what they referred to as “The Big Three.”  They are:

·         Interest rates and compounding.
·         Inflation
·         Risk and diversification

In the WALL STREET JOURNAL article, Ms. Lusardi is quoted as saying “Individuals also need to be savvy about debt.” Another survey she worked on asked the following: “If you had a credit card that charged 20% annual interest, how long would it take for the amount owed to double if you didn't pay anything off or charge anymore?”
“Just 36% of adults recognized that 20% interest, compounded, would double in less than five years.”  In a more recent article (Feb 16th 2013), the ECONOMIST magazine quoted an even more startling example in an article entitled “Teacher, leave them kids alone: Financial education has haddisappointing results in the past.”

Both articles quote incredibly high portions of the population not understanding compounding, yet the questions in both articles are clear.  One has to wonder how many people would reduce their credit card balances if they understood.  It would seem to be a fairly safe to bet that it would be less than 64% (100%-36%). 

In fact, the ECONOMIST article cites a number of sources that would indicate that a lack of understanding of how compounding works is only part of the problem. First, the ECONOMIST cites a survey by the Federal Reserve Bank of Cleveland (“Do Financial Education Programs Work?” April 1, 2008, FRB of Cleveland Working Paper No. 08-0).  The report is summarized as finding that: “Unfortunately, we do not find conclusive evidence that, in general, financial education programmes do lead to greater financial knowledge and ultimately to better financial behaviour.”  Second, a survey of students from a Midwestern state found that those who had not taken a financial course were more likely to pay their credit card in full every month (avoiding fees and charges) than those who had actually studied the subject.

Part of the failure of financial education is that it only deals with the mathematics of how financial management works.  It would be far more effective if it were grounded in the simple day-to-day, “real life” implications.  For example, the simple statement that “if you spend whatever you have, you will always be broke” may be more effective than a lesson on budgeting.  Similarly, pointing out that “if you never spending everything you have you will never be broke and will probably end up fairly well off,” would be equally affective.  The simple statement that “borrowing money to buy something always makes it more expensive, and therefore involves giving up additional things you could have,” may be more effective than a lesson on compounding.   

Financial management can be boiled down to a few simple principles.  Interest rate compounding, inflation, and risk and diversification are important, but one suspects that often the failure of financial management education results from the fact that stating simple truths is sometimes painful.  No one likes to accept the fact that there are limits.  As a consequence, financial management education often focuses on how to try to avoid the limits rather than on what those limits are.  The limits are unavoidable.