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Thursday 8 October 2009

Financial Education Doesn't Work

Education? Slowly Does It

Many people, myself included, have felt that a good dose of financial education may be just what the world needs to save itself from monetary predation. After all, the nature of capitalism is that companies will seek to maximise their profits at the expense of the ill-prepared: so training people seems like a sensible counter to this position.

Unfortunately it seems we're wrong and that educating people about money works slowly, if it works at all. That doesn’t mean we shouldn’t make the effort, but for the majority of people it’s not an answer because they forget all they’ve been taught just as soon as some spiv in a suit comes along waving around cheap money. Most people just can't help themselves from helping themselves to new stuff now, no matter what the future cost.

Money Dumb

The level of financial innumeracy in developed nations is quite staggering if we’re to believe the research. 80% of people in the UK, for instance, have no idea what the true cost of a loan is. Mostly they just look at the initial cost; which of course is why teaser rates on mortgages are so effective – it's just the psychological bias of discounting the future cost of things in favour of getting hold of something you really want now appearing in a different form.

Research on US consumers by Lusardi and Mitchell (2006) simply backs up the evidence from elsewhere. They find that only a third of older Americans – those who should be most concerned about retirement savings – are able to answer these three relatively simple but important questions.
  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: more than $102, exactly $102, 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, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
  3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”
Low Standards, Globally

You might well feel that being able to answer these questions constitutes a pretty low standard for financial literacy – the ability of a consumer to make financial decisions in their own best interests – but these findings have been replicated across other developed nations. An OECD study in 2005 showed that people acting dumb when it comes to money is a truly globalised phenomenon across Europe, Australia and Japan in addition to America. Still, it's nice to know we all have something in common apart from global warming.

Anyway, unsurprisingly, it seems that those people who can’t calculate compound interest very well are far less likely to save enough to retire on being apt to spend any money they can get their hands on as quickly as possible on nice, shiny new things. They’re also less likely to invest any money in the stockmarket which, of course, may not be a bad thing: if you’re too dumb to figure out the real cost of your new TV you’re probably not going to be very smart at stock picking. Frankly, it's a wonder they can figure out how to use the remote.

So Educate Them?

One solution to this, you might think, is to provide financial education. From a government perspective this might have a couple of beneficial effects. Firstly future pensioners would save properly and be less of a burden, so that the legislators would have more money to pay themselves gold-plated, index-linked retirement benefits. Secondly, it would obviate the need to enact laws to make financial institutions behave themselves, which is difficult when they’re likely to be your next employer, such is the revolving door between governments and the money men. Unfortunately the evidence suggests that not only are we not very good at doing our investment sums but also we’re not very good at learning about doing our investment sums either.

Some decent research shows that basic education is a determinant of financial literacy. Van Rooij, Lusardi and Alessie (2007) carried out a complex study of these issues in the Netherlands. In amongst a wide set of findings, many of which are seriously thought provoking – including the possibility that the higher levels of stockmarket investments in older age groups is a facet of the fact that richer people tend to live longer – they show that an economics education in under 16's, but not after, is predictive of higher levels of financial literacy and greater investment in stocks.

Lab Rats

The evidence from various studies on whether targeted financial education on adults improves financial literacy is, at best, inconclusive. As Mandel (2009) reports:
"In four of the surveys [from 2000 to 2008], including the 2008 survey, students who took a full semester course in money management or personal finance actually had slightly lower mean financial literacy scores than all students. "
Which is depressing, even if it’s not definitive.

There is one type of training that does seem to improve the situation – the so-called stockmarket game in which students actively participate in their learning approach. This produces a 6 to 8% improvement. Researchers seem to be puzzled by why this might be the case but there’s plenty of psychological research around that shows how active involvement in learning situations improves student ability to use the training afterwards.

Regardless, the stockmarket game success turns out to be a pyrrhic victory because the successful students then go on to save less than their peers. The (unsubstantiated) hypothesis is that they learn that they can make up for failing to save by taking additional risks on the markets. Which is of course, what happens when you treat people like lab rats – they figure out how to get the cheese for as little effort as possible: proponents of ‘Nudge’ techniques beware.

The Epistemological Puzzle

There is another possible answer to some of the puzzles in this area related to epistemology – the study of knowledge. Psychologists generally make a distinction between two types of ‘knowing’. There’s ‘knowing about’ things: so we know that Washington is the capital of the USA and that 2 + 2= 4. However, there’s also ‘knowing how to’ do things – such as how to operate a word processor or how to calculate compound interest.

Mandel’s research suggests that the most financially literate college students are not economics or business graduates who ‘know about’ financial matters but engineers and scientists who ‘know how’ to solve problems. Which suggests you’d be better off taking financial advice from the guy who designed your tax return software rather than the one that filled it in for you.

The Dangerous Trap of Financial Education

The research also notes that, although financial literacy doesn’t seem to be improved by education, financial behaviour – in terms of saving, for instance – is. Which, of course, may actually make things worse: financially illiterate but savings oriented consumers are the perfect fodder for the next Ponzi scheme merchant, a dangerous trap if there ever was one.

Broadly speaking, then, financial education appears to only have a marginal effect on people’s financial capability, although it does seem to promote more efforts to prepare for the future. This being the case, however, it’s unlikely that we can rely on better training to improve the global problems with financial literacy. With less and less government retirement provision and less and less generous company pension schemes (not to mention ever decreasing job security) this is no longer a looming problem.

It’s already loomed, and we’ve now got to figure out how to deal with it.

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  1. There’s ‘knowing about’ things: so we know that Washington is the capital of the USA and that 2 + 2= 4. However, there’s also ‘knowing how to’ do things – such as how to operate a word processor or how to calculate compound interest. Mandel’s research suggests that the most financially literate college students are not economics or business graduates who ‘know about’ financial matters but engineers and scientists who ‘know how’ to solve problems.

    The article is brilliant and balanced.

    I believe the words quoted above are the key to developing a solution to the problem. Most people don't care to learn about money topics. The problem is not that they are dumb. The problem is that they are unmotivated. But everyone is forced to save and invest. So lots of people who don't want to be engaging in money actions are engaging in them anyway and have little interest in learning how to do so effectively. What to do, what to do?

    The answer that most have come up with is -- put your faith in "experts." But the people we think of as "experts" in this field generally possess only a limited understanding of what works. They have developed the skills needed to appear to possess expertise. They cite "studies." They use fancy lingo. They practice sounding confident of their views. That's about it. If you ask hard questions, they run. They do not possess the deep knowledge that in other fields qualifies one as an "expert."

    Our knowledge of how saving and investing works is primitive. There is lots of good work being done (this blog is one example of a place where good work is being done, in my assessment). But a lot of the good work is ignored by the "experts" because they feel that it makes them look bad for them to acknowledge that they did not always know everything there was to know. What the investing world needs now is humility, sweet humility. That would open us up to all sorts of wonderful advances.

    The sad reality is that it is going to take a lot of pain to open people up to the benefits of humility. I believe that our economic crisis is in the process of supplying the needed pain. What is unclear is whether as a society we will act quickly enough in developing the humility we need to stop our economic and political system from going over a cliff.

    We are a richer people than we ever were before. On the surface, that sounds like a good thing. But being richer is like being stronger. There are dangers involved if you don't approach attaining more power in a responsible way. It is only now beginning to dawn on us that we don't know it all and that we have put ourselves in horrible circumstances by pretending to ourselves that we did. If we act,though, I think it could be that our knowledge of how saving and investing works could advance dramatically in a small number of years.

    The rule is: Humility first, then knowledge.


  2. Buried in the middle of the post is a nugget of critical information...that educating people under 16 seems to lead to higher financial literacy. Perhaps we can't fix the adults and the short-term future but we can educate the current student population and benefit the long-term.


  3. Hi Susan

    You're stealing my (future) thunder :-)

    But it's a good point - see Bernheim, Garrett and Maki (2001) on the effects of high school financial curriculum mandates, for instance. It seems to work, but it takes a long time to be seen.

  4. Using the Wharton study as support, you have decided that "Financial Education doesn't work"?

    And of course, a loon or two like noted crank Rob Bennett use that to jump on the bandwagon ("The article is brilliant!") to tout their own special brand of lunacy.

    How about we back up just a bit.

    Here is a quote directly from the study itself:

    "Differences in financial knowledge across education groups (Figures 2a-c) confirm our expectation that financial literacy is highly correlated with schooling. Most importantly, financial illiteracy is acute among those with less than a high school degree."

    The more education you have, the more financially literate you are likely to be. Pretty much the OPPOSITE of what you are claiming.

    So, with regard to your ridiculous premise as well as it's conclusion... frankly, there is "nothing to see here, move along..."

    Here are the literal last words of the study:

    "... if financial illiteracy is widespread among particular employees, a one-time financial education lesson is likely to be insufficient to influence planning and saving decisions. Similarly, education programs targeted specifically to particular subgroups may be better suited to address large differences in preferences and saving needs."

    So rather than claiming that financial education will not work, they are instead stating that it likely needs to be better targeted and more sustained in order to increase effectiveness! Hardly the conclusion you draw in your blog.

    Whatever happened to critical thinking AND reading?

  5. We keep thinking that financial literacy is about teaching people to SAVE. That's just one tiny piece of the behavior puzzle that people have to learn in order to end up financially savvy and secure.

    It's takes saving AND investing AND thinking about money and investing in the right way to really make a difference and I agree that financially ignorant people who DO save are often in a prime position to be taken advantage.

    The problem with financial education is that it is compartmentalized when it is taught. There's no foundation laid first of right thoughts, beliefs and attitudes about money and wealth creation.

    The other reason financial education generally doesn't work is that it is BORING and not relevant, especially for kids. It is generally taught auditorilly, people take a ton of notes, have no visceral experience of what they are learning so that it doesn't stick.

    There are ways to empower people with financial skills and there are powerful strategies to teach kids about money but for the most part, none of these strategies are used.

    What a shame...

  6. Hi Elisabeth

    You're quite right. The problem I have with virtually all training programs, no matter whether they're good or not, is that they're outdated almost as soon as they're finished given the constantly mutating nature of viral financial products.

    While even relatively simple financial products need to be accompanied with a small book of fine print there's not much chance of the woman or man in the street keeping up. Unpalatable though it may be we either have to regulate advisory separation from financial providers or regulate the complexity of financial products. Only then will our kids stand a chance of being educated.

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