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Saturday, 23 January 2010

Freedom Of Financial Choice Is A Myth

Finance Isn't Child's Play

As we’ve navigated the nether regions of investing folklore like a drunken Frankenstein’s monster in search of a late night high cholesterol snack you may have formed the opinion that this author is somewhat sceptical of all investment processes that don’t explicitly guard against human psychological perversity and highly doubtful that those that do can overcome ingrained biases and an industry dedicated to causing us to do exactly the wrong thing at exactly the wrong time. Still, scepticism isn’t cynicism, and along the way we’ve found one small chink of light in the gloom; the finding that if you give people a financial education early enough in life it improves their money management.

Well, for all you folks out there preparing to send little Jimmy and Jemima to financial summer school don’t bother, because you’d be better off giving them your credit cards and dropping them at the nearest mall for a day. Sadly educating our kids about money doesn’t improve their investing decision making. In fact there's a pretty strong argument that nothing does and it's time to stop blaming people for allowing themselves to be exploited: the idea that everyone can be a financial expert is a myth. Time for a different approach?

Does Educating the Under 16's Help?

Back in Financial Education Doesn’t Work we looked at the research showing that training in financial matters doesn’t improve peoples’ money management. Indeed, sometimes it makes things worse. However, some of the research in this area suggested that if you can give under 16’s some economics education the long-term effects of this are strikingly beneficial.

The key research in this area was from Bernheim, Garrett and Maki who showed that mandates requiring schools to provide personal finance education were correlated with higher levels of savings later in life. Teasing this information out wasn’t easy because we’re talking about periods of decades between the education being provided and the savings being accumulated. Such long term research, known as a longitudinal study, is notoriously difficult to run simply due to the elongated periods over which it must be conducted and the likelihood of the participants doing odd and unreasonable things like dying or developing an obsession about the end of the world and hiding out in a mountain cave with enough baked beans to float a balloon.

Education Doesn't Help Financial Literacy

In contrast to the Bernheim, Garrett and Maki findings the Jump$tart Coalition for Personal Financial Literacy has run surveys of US high school seniors since 1997 and have shown a distressing fall in financial literacy. In essence, the financial education which is supposedly fresh in the minds of those groups of young people about to launch themselves into adulthood doesn’t seem to have stuck. This is a replication of a finding seen in other contexts – most notably that the financial understanding of economics students declines following financial training. The summation of the findings is provided in this report by Lewis Mandell, who also provides a much more detailed review of the work in this area than I have space for.

Now the Jump$tart findings clearly matter because if we can’t find a way of educating people about financial matters then we’re pretty much stuck when it comes to improving the financial services industry. If humans can’t understand the basics of compound interest, credit card costs, index tracker fees and variable rate mortgages then they’ve absolutely no chance of grasping the essence of mean reversion, stock valuation and exotic derivatives. Although, to be frank, it’s not actually clear that anyone really understands the latter: the suspicion is that many of these acronymic weapons of wealth destruction are generated by a computer programmed to spit out random numbers and are fronted by actors with weird hair who specialise in misdirection. Seems to have worked so far.

Financial Education Can't Work

In fact there’s worse to come, because if we can’t find a way to educate people and we can’t overcome the implicit biases within the financial advisory industry then we’re more or less forced to go back to the drawing board and start redesigning financial products so that people can’t make mistakes. Lauren Willis in Against Financial Literacy Education puts it thus:
"The gulf between the literacy levels of most Americans and that required to assess the plethora of credit, insurance, and investment products sold today—and new products as they are invented tomorrow—cannot realistically be bridged. Educators would need to impart a sophisticated understanding of finance because rules of thumb are not useful for decisions about complex products in a volatile market. Further, high financial literacy can be necessary for good financial decision making, but is not sufficient; heuristics, biases, and emotional coping mechanisms that interfere with welfare-enhancing personal finance behaviors are unlikely to be eradicated through education, particularly in a dynamic market. To the contrary, the advantage in resources with which to reach consumers that financial services firms enjoy puts firms in a better position to capitalize on decision making biases than educators who seek to train consumers out of them."
Bascially, the average human being doesn’t stand a chance in today’s complex financial markets and financial education isn’t going to solve the problem. Willis’ paper is brutal about the financial education model believing that it enshrines a myth about consumer self-reliance that then allows those self-same consumers to be blamed for their greed when everything goes wrong. If this model is fatally flawed because people can’t learn this stuff then the whole idea of consumer self-sufficiency in financial markets needs to be rethought, which ultimately leads to some pretty serious questions about the nature of those markets and their regulation. Perhaps most cuttingly Willis observes:
"That [the financial] industry supports financial literacy education is, while indirect, perhaps the strongest evidence that this education is not effective in improving consumer financial decisions"
Factors in the Failure of Financial Education

Four main factors preventing the success of financial education programs are identified:
  1. Information Asymmetries and Chasing Moving Targets. Put bluntly, there’s simply too much choice in the marketplace, and the development of niche targeted products worsens the problem as they’re marketed to people outside of their original niches. No one can possibly cope with the complexity of the range of financial products in the market.
  2. Insurmountable Knowledge, Comprehension and Numeric Skill Limitations. People simply don’t have the basic skills needed to even begin to understand the nature of the products that they’re being offered. For example, Willis quotes the research showing that after 40 years of use only 10% of consumers have any understanding of what an APR is.
  3. Poor Conditions for Debiasing. Cognitive biases, as we’ve repeatedly seen, drive people into wealth destroying behaviours and the nature of financial markets provides a poor environment for overcoming these. Indeed, financial education can create an illusion of control and lead to unwarranted overconfidence in financial decisions, with predictable results.
  4. Reaching Consumers at Teachable and Vulnerable Moments. A “teachable moment” is one at which a person is particularly receptive to the education on offer. For financial education this would normally be when an important decision is being made – buying your first house, acquiring your first credit card, etc. Willis argues that these moments are the points at which lifelong preferences are generated and then that they’re more likely to be set by the deep pockets of the financial services industry than by educators.
Don't Bother With Financial Education

The conclusion is depressing:
"Given the foregoing, the failure to find any empirical evidence that the financial literacy education model works is not surprising. In light of the velocity of change in the consumer credit, insurance, and investment marketplace, the innumeracy of much of the population, the prevalence of decision making biases, and the financial advantage held by sellers of financial products, financial literacy education should not be expected to work."
Given all of this what should we do? Well that’s a question for another day, but if interested parties want to avoid blaming the financial industry for the screwing up of pretty much everything then their only route out is through financial education – because only then can they continue to censure individuals for their mistakes, rather than acknowledging the widespread deceit that lies at the heart of the problem. Fact is, swamping people who have low levels of financial literacy – which is the majority of us – with a vast array of over-complicated products designed to feed their innate biases is just a cast iron way of ensuring another financial crisis is lurking just around the corner.

Related Articles: The Lottery of Stockpicking, Financial Education Doesn't Work, Save More ... Tomorrow


  1. But was it not the most financially sophisticated investors and traders at the banks that caused the problems? It was their CDOs, derivatives and risk arbitraging that caused the crash. As they designed them they understood them, or at least thought they did.

    Where Joe Public went wrong was with very simple debt products like credit cards and mortgages.

    The best education would be a small recession every five years or so.

  2. I suspect there's some sort of arm's race going on - so if you educate people then the financial companies simply up their game again.

    1950s financial choices were pretty straightforward, with a paternal state and the same attitude from monolithic employers. Was debt etc less of a problem then, or were people still conned and scammed? I genuinely don't know.

    Rob, I sort of agree but the people who invented many of those products did very well out of them and moved on. Even the likes of Chuck Prince left with their mega-millions. In the financial mindset of many of these people, they played a good hand - all reward, and little risk if the reward isn't recoupable.

  3. Even the simplest and most important decisions are unbelievably complex.

    Financial training to buy a house at the right price and time?

    If even Jamie Dimon can't see falling house prices coming and the entire universe of investment banks themselves, then what hope mankind?

  4. I think you are very much on the right track in rejecting the idea of financial "education." Tim. I do not at all share your sense of hopelessness, however.

    Investing is NOT complicated. With index funds now available to us, we can all invest in a simple and highly profitable way.

    The only thing standing in our way is The Stock Selling Industry's tireless promotion of Buy-and-Hold. Telling investors that price does not matter when buying stocks teaches precisely the wrong lesson. Buy-and-Hold appeals to the Get Rich Quick impulse that lives within all of us and that makes stock investing a bad choice for most middle-class people in the long term.

    The answer is to teach precisely the OPPOSITE lessons of what we have been teaching for the past 30 years. Instead of telling people to ignore price when buying stocks, we should be telling people to ALWAYS take price into consideration. When we do that, all of the confusion now associated with stock investing goes "Poof!"

    We should be buying stocks in the way that we buy everything else. When stocks offer a strong long-term value proposition, we should buy heavily. When stocks offer a poor long-term value proposition, we should sell heavily. When stock investing begins to make sense, all of these behavioral issues will be a thing of the past. People want to invest effectively. They just have a hard time believing that so many who are thought of as being "expert" have managed to get it all so horribly wrong.


  5. To follow up on Rob Bennett's post, Better Investing:

    provides an easy way for a HS-educated person to successfully value stocks, including higher level concepts such as sector/capitailzation allocation, portfolio management, etc.

    While I don't dispute the findings of the study, the authors seem to have begged the question. For example, one could make a decision to avoid debt. While that stance would entail a greatly different lifestyle, it eliminates a whole class of decisions that don't have to be made. The same could be said for savings, investing, real estate, taxes, etc.

    I am very confident that basic core principles on saving, debt, investing, insurance, legal can be taught to, and applied by, the average person. In fact, I've helped a number of friends self-learn over the past 20 years (I'm in my early 40s), and now I'm teaching my children. The key is for the instruction to come from someone whose livelihood doesn't depend on the actions of those being taught.

  6. "Buy-and-Hold appeals to the Get Rich Quick"

    What? Buy and hold only works over a sufficiently long time frame. In no way is it a get rich quick scheme. It's also not a myth: our system of living is geared towards increasing its inherent value. The only thing I'm ever sure about when I look at the FTSE is that the long term trend is up.

  7. I wrote a recent commentary on my own site that pretty well comes to the same conclusions: see Financial literacy programs: more savings, not better investing? at the following link

    In a nutshell, financial education programs are contaminated by the excessive influence of the financial services industry.

    Marc Ryan,

  8. @Rob Bennett

    Disclosure: Rob Bennett makes money by selling financial advice. But that unfortunately won't make you any less likely to listen to him.

  9. @anonymous

    Is this Rob Bennett the "Passion Saving" Rob Bennett? It smells like it could be...