I have not been writing for a while, but have been reading about and watching the current economic crisis unfold. This is humbling, and there are many reasons to worry. One of the assumptions behind the sound functioning of markets is that the agents who stand behind demand and supply are well informed and rational. But, as I have argued in many previous blogs, there is reason to question that assumption in the face of widespread financial illiteracy. Of course, my studies of illiteracy focus on consumers, but the current events make me wonder about politicians. Perhaps there is need for a crash course in financial markets and money and banking down in Washington. I do not mean this in a sarcastic way, but rather express it with genuine concern; the lessons we should have learned from the past are seemingly being ignored. My views may be colored by the fact that I was a student of Ben Bernanke at Princeton, but his article on the collapse of the financial sector as a factor in transforming a recession into the Great Depression still resonates (for anyone interested in reading it, the article was published in the American Economic Review back in 1983). It teaches us that the financial sector is vital to the workings of the economy and that shutting it down may send the economy into a tailspin. The role of the financial system in the economy is critical: it channels the funds of savers to the firms and entrepreneurs who need them. Lack of credit prevents not only businesses from investing but also households from consuming and buffering against economic shocks. In other words, a financial system that is not working or that is limping can affect the macro economy and each of us individually. We do not want the economy to go that route.
There is an inherent instability in both the banking system, with its fractional reserve system (only a small fraction of deposits are kept in the banks, so if all depositors wanted to withdraw their deposits, there would not be enough funds to make it possible) and in financial markets, in which large sums of money can be moved very quickly. Several institutions and mechanisms are in place to counteract that instability, one example being the Federal Deposit Insurance Corporation, or FDIC. Some may argue that these institutions do not work very well; for example, what banks pay to be insured by the FDIC often does not reflect their actual risk. In reality, financial markets continually innovate. Moreover, financial instruments have become very complex in terms of risk. Derivates, such as options and futures, make it possible to take up large amounts of risk. Regulation has certainly not kept up with that.
When a financial crisis occurs, it is important to act quickly. Now more than ever we need to have economics and finance rule politics.
Thursday, 2 October 2008
Wednesday, 20 August 2008
Are We a Nation of Financial Illiterates? Some Comments
Stephen Dubner, one of the authors of Freakonomics, has posted an article on his blog (link is just below) that addresses this question: Are we are a nation of financial illiterates?
http://freakonomics.blogs.nytimes.com/2008/07/21/are-we-a-nation-of-financial-illiterates/
If you have read Freakonomics, you know he is a gifted writer. In his blog, he poses three critical questions. I modified these questions slightly (they are listed below), and added some discussion.
1. Are we a nation of financial illiterates?
2. How did we get that way?
3. How important is widespread financial literacy to the health of a modern society?
The answer to the first question is unfortunately a yes. In surveys after survey after survey, we find that the majority of the U.S. population lacks knowledge of some of the most fundamental financial concepts, such as the power of interest compounding, the workings of risk diversification, and basic asset pricing. In one of my most recent surveys, I measured “debt literacy,” or knowledge of the concepts related to debt and borrowing. Results are humbling: only one-third of the population has a good grasp of the workings of credit cards and understands how quickly credit card debt can grow when borrowing at the standard rates.
The answer to the second question is more complicated. While the quality of schooling education in general may be cause for concern (relevant statistics are not comforting), the financial landscape in the United States has changed dramatically in recent decades. One of the most notable changes has to do with retirement planning. In the past, the average worker did not have to make any decisions about his or her pension. Pensions were mostly defined benefit plans entirely overseen by the employer, so there was little incentive or rationale for individuals to learn about saving and investment. Today, the average worker needs to decide how much and how best to save for retirement—a decision that can be daunting and, if implemented poorly, that can result in inadequate preparation for retirement. Thus, the incentives and the reasons to learn how to save and invest were less pressing. Similarly, until quite recently, the financial instruments that people needed to deal with were fairly basic. When purchasing a new home, a typical household in the 1960s or 70s would likely get a 30-year fixed rate mortgage from a local bank. Today, the complexity of mortgages has increased dramatically and so has the number of lenders, making the process of financing a home a much more complicated endeavor. So, in answer to the question—how did we come to be a nation of financial illiterates?—perhaps it’s not that we have become less financially literate than in the past, but that the world around us, with it’s increasingly complex financial instruments and increasing demand for personal responsibility, is changing.
The answer to the third question—how important is financial literacy to the health of modern society?—is not an easy one either. It is difficult to assess the effects of financial literacy. Financial literacy is not distributed randomly among the population; it is often the result of personal choice, of parents’ education, and of an individual’s access and exposure to financial education. There are very few experiments we can rely on to assess whether or not financial illiteracy results in financial mistakes. Nevertheless, studies consistently show that those who display low levels of financial literacy are less likely to display healthy financial behavior. And in the modern economic system in which we all live, we have to make sure we are well equipped to make the financial decisions that confront us.
Coming back to Dubner’s blog, I am happy to see that it has generated a lot of comments (more than 200 as of today). One reader responded to Dubner’s posting with a fourth question (slightly modified here):
4. Which name doesn’t belong: Faulkner, Curie, Pasteur, Friedman?
My answer is Faulkner. The other authors have made important discoveries that have shaped science and public policy. One of the remarkable lessons we have learned from Milton Friedman is that “inflation is always and everywhere a monetary phenomenon.” This means that if the central bank does not change the money supply, prices will not keep increasing, even in the presence of an oil shock. Now, this is pretty useful to know, don’t you think?
http://freakonomics.blogs.nytimes.com/2008/07/21/are-we-a-nation-of-financial-illiterates/
If you have read Freakonomics, you know he is a gifted writer. In his blog, he poses three critical questions. I modified these questions slightly (they are listed below), and added some discussion.
1. Are we a nation of financial illiterates?
2. How did we get that way?
3. How important is widespread financial literacy to the health of a modern society?
The answer to the first question is unfortunately a yes. In surveys after survey after survey, we find that the majority of the U.S. population lacks knowledge of some of the most fundamental financial concepts, such as the power of interest compounding, the workings of risk diversification, and basic asset pricing. In one of my most recent surveys, I measured “debt literacy,” or knowledge of the concepts related to debt and borrowing. Results are humbling: only one-third of the population has a good grasp of the workings of credit cards and understands how quickly credit card debt can grow when borrowing at the standard rates.
The answer to the second question is more complicated. While the quality of schooling education in general may be cause for concern (relevant statistics are not comforting), the financial landscape in the United States has changed dramatically in recent decades. One of the most notable changes has to do with retirement planning. In the past, the average worker did not have to make any decisions about his or her pension. Pensions were mostly defined benefit plans entirely overseen by the employer, so there was little incentive or rationale for individuals to learn about saving and investment. Today, the average worker needs to decide how much and how best to save for retirement—a decision that can be daunting and, if implemented poorly, that can result in inadequate preparation for retirement. Thus, the incentives and the reasons to learn how to save and invest were less pressing. Similarly, until quite recently, the financial instruments that people needed to deal with were fairly basic. When purchasing a new home, a typical household in the 1960s or 70s would likely get a 30-year fixed rate mortgage from a local bank. Today, the complexity of mortgages has increased dramatically and so has the number of lenders, making the process of financing a home a much more complicated endeavor. So, in answer to the question—how did we come to be a nation of financial illiterates?—perhaps it’s not that we have become less financially literate than in the past, but that the world around us, with it’s increasingly complex financial instruments and increasing demand for personal responsibility, is changing.
The answer to the third question—how important is financial literacy to the health of modern society?—is not an easy one either. It is difficult to assess the effects of financial literacy. Financial literacy is not distributed randomly among the population; it is often the result of personal choice, of parents’ education, and of an individual’s access and exposure to financial education. There are very few experiments we can rely on to assess whether or not financial illiteracy results in financial mistakes. Nevertheless, studies consistently show that those who display low levels of financial literacy are less likely to display healthy financial behavior. And in the modern economic system in which we all live, we have to make sure we are well equipped to make the financial decisions that confront us.
Coming back to Dubner’s blog, I am happy to see that it has generated a lot of comments (more than 200 as of today). One reader responded to Dubner’s posting with a fourth question (slightly modified here):
4. Which name doesn’t belong: Faulkner, Curie, Pasteur, Friedman?
My answer is Faulkner. The other authors have made important discoveries that have shaped science and public policy. One of the remarkable lessons we have learned from Milton Friedman is that “inflation is always and everywhere a monetary phenomenon.” This means that if the central bank does not change the money supply, prices will not keep increasing, even in the presence of an oil shock. Now, this is pretty useful to know, don’t you think?
Tuesday, 5 August 2008
Why Financial Literacy Matters
In my previous blog, I posted three questions that can be used to measure financial literacy. In this posting, I want to discuss the answers to those questions and why getting them right matters.
The first question is:
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?
This question measures numeracy and knowledge of the power of interest compounding. The fact that interest grows on interest is an important concept to understand and explains how your investment can grow quickly over time.
There are two lessons to be learned from this concept:
1) To make the power of interest compounding work in your favor, it is important to start to save when you are young. Just a simple example: $1 invested at a 7% interest rate increases more than 7 fold in 30 years. This is pretty good, yes? (But see discussion of inflation below.)
2) It is important to borrow as little as possible with credit cards or through other high cost means. Borrowing at an interest rate of 20% means that it takes fewer than 5 years for your debt to double. To me, this seems to quickly hurt.
The second question is:
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?
This question measures knowledge of inflation. Inflation is simply the change in prices overtime. If prices increase, it means you can buy less with your money.
There are two lessons to be learned from this concept:
1) You need to protect against the erosion of your purchasing power. Because of inflation, the money you have today will buy less in the future, so you need to invest your money at an interest rate that is higher than the inflation rate. If inflation is at 3% and you earn 1% on your savings account, believe me, you are not doing well!
2) It is important to take inflation into account when planning for the future. In other words, do not expect the prices tomorrow to be the same as the prices today.
The third question is:
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.”
This question measures knowledge of risk diversification. This is a very important concept that relates to the old adage 'don’t put all of your eggs in one basket.' A simple fall and you have a "frittata," as we say in Italian.
Again, there are lessons to be learned from this concept:
1) Make sure that a single event does not put a big dent in your investment. For example, why invest in a single stock? Why give all of your money to your brother-in-law who wants to open a cigar shop? Firms can fail and people can stop smoking.
2) Investing in your company stock is very risky; if your company goes under, you will lose the money you invested when you need it most. Even if you like your company a lot, why take so much risk? Clearly, I am lucky; Dartmouth is not listed on the NASDAQ and I do not have to face this decision.
The first question is:
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?
This question measures numeracy and knowledge of the power of interest compounding. The fact that interest grows on interest is an important concept to understand and explains how your investment can grow quickly over time.
There are two lessons to be learned from this concept:
1) To make the power of interest compounding work in your favor, it is important to start to save when you are young. Just a simple example: $1 invested at a 7% interest rate increases more than 7 fold in 30 years. This is pretty good, yes? (But see discussion of inflation below.)
2) It is important to borrow as little as possible with credit cards or through other high cost means. Borrowing at an interest rate of 20% means that it takes fewer than 5 years for your debt to double. To me, this seems to quickly hurt.
The second question is:
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?
This question measures knowledge of inflation. Inflation is simply the change in prices overtime. If prices increase, it means you can buy less with your money.
There are two lessons to be learned from this concept:
1) You need to protect against the erosion of your purchasing power. Because of inflation, the money you have today will buy less in the future, so you need to invest your money at an interest rate that is higher than the inflation rate. If inflation is at 3% and you earn 1% on your savings account, believe me, you are not doing well!
2) It is important to take inflation into account when planning for the future. In other words, do not expect the prices tomorrow to be the same as the prices today.
The third question is:
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.”
This question measures knowledge of risk diversification. This is a very important concept that relates to the old adage 'don’t put all of your eggs in one basket.' A simple fall and you have a "frittata," as we say in Italian.
Again, there are lessons to be learned from this concept:
1) Make sure that a single event does not put a big dent in your investment. For example, why invest in a single stock? Why give all of your money to your brother-in-law who wants to open a cigar shop? Firms can fail and people can stop smoking.
2) Investing in your company stock is very risky; if your company goes under, you will lose the money you invested when you need it most. Even if you like your company a lot, why take so much risk? Clearly, I am lucky; Dartmouth is not listed on the NASDAQ and I do not have to face this decision.
Saturday, 12 July 2008
Are You Financially Literate? Do this Simple Test to Find Out
One component of my “financial literacy initiative” is to provide (and share) ideas, suggestions, and tools to people interested in financial literacy. While I have discussed extensively financial literacy in previous blogs, I have not discussed how to measure financial literacy. However, this is a major part of the academic research I do. Together with Olivia Mitchell, I have devised three questions that are pretty successful into classifying respondents into levels of financial knowledge. I report the questions below. I urge all of the readers of this blog to go through these questions. In my view, it is important that we evaluate how much we know and simple tests like this one can serve this purpose (ok, I admit, it is the academic in me speaking…). Moreover, we could use these simple tests to classify respondents into different types and assign them to different groups. For example, new hires could be given a test to assess their financial knowledge; those who display little knowledge could be advised to consult with the HR office or a financial advisor before selecting their pension fund and the allocation of their pension assets. Why make important financial decisions ourselves if we know little or nothing about finance and economics? (And beware of asking your brother in law, chances are he knows much less than you were hoping for, but now there is a way to find out!).
Here are the 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?
a) More than $102
b) Exactly $102
c) Less than $102
d) Do not know
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?
a) More than today
b) Exactly the same as today
c) Less than today
d) Do not know
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.”
a) True
b) False
c) Do not know
The answers are reported at the very end. To be “financially literate” you need to answer correctly to all three questions. If you are able to answer correctly to two questions only, you are not in bad shape (in particular if you were able to answer correctly to the third question), but you need to improve your financial knowledge. If you answered correctly to one question, you are not in good shape and you need to improve your financial knowledge. If you got all questions wrong, you did not get a passing grade. If your answer was “do not know” to at least two of these questions, you are also not in good shape.
Now, let’s admit it, it is not fun to go through these types of tests and it is even less fun to find out that we do not know the answers to these questions. While this is true, it is also the case that how much we know influences how well we do in our financial choices. So, let’s leave these concerns aside and take the test. Financial literacy pays off! And next time your brother in law advances a suggestions on the stock you should buy in this turbulent market, smile and quickly shift the discussion to the weather (it works very well, at least in New Hampshire where the weather changes even more erratically than the stock market).
Answers
1. a) More than $102
2. c) Less than today
3. b) False
Here are the 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?
a) More than $102
b) Exactly $102
c) Less than $102
d) Do not know
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?
a) More than today
b) Exactly the same as today
c) Less than today
d) Do not know
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.”
a) True
b) False
c) Do not know
The answers are reported at the very end. To be “financially literate” you need to answer correctly to all three questions. If you are able to answer correctly to two questions only, you are not in bad shape (in particular if you were able to answer correctly to the third question), but you need to improve your financial knowledge. If you answered correctly to one question, you are not in good shape and you need to improve your financial knowledge. If you got all questions wrong, you did not get a passing grade. If your answer was “do not know” to at least two of these questions, you are also not in good shape.
Now, let’s admit it, it is not fun to go through these types of tests and it is even less fun to find out that we do not know the answers to these questions. While this is true, it is also the case that how much we know influences how well we do in our financial choices. So, let’s leave these concerns aside and take the test. Financial literacy pays off! And next time your brother in law advances a suggestions on the stock you should buy in this turbulent market, smile and quickly shift the discussion to the weather (it works very well, at least in New Hampshire where the weather changes even more erratically than the stock market).
Answers
1. a) More than $102
2. c) Less than today
3. b) False
Tuesday, 1 July 2008
The Financial Literacy Initiative
It is official: Today marks the start of my “Financial Literacy Initiative.” Thanks to the support of several institutions, including Dartmouth College and the Financial Industry Regulatory Authority, I can now launch this new initiative. For those of you who have not followed my work closely, I have devoted my research in the past six years to financial literacy and topics related to financial literacy (for example, financial education). My work will not only intensify but will also aim to a large public. In this blog, you will read not only how to measure your financial literacy but also how to improve your financial literacy. You will also read about the results of academic research (not only mine but also those of other authors) that provides useful suggestions and recommendations for our financial decisions, and much more!
Let me start this initiative by summarizing as briefly as possible what I have done so far. My work will continue from here.
In collaboration with Olivia Mitchell from the Wharton School, I have documented an alarmingly low level of financial literacy among older people in the United States. In our sample of older respondents from the Health and Retirement Study, we find that over half of respondents cannot undertake a simple calculation regarding interest rates over a 5-year period and do not know the difference between nominal and real interest rates. An even larger percentage of respondents do not know whether or not a single company stock is riskier than a stock mutual fund. We have also shown that financial illiteracy is related to the inability to devise and implement financial plans. That is, one reason people fail to plan is because they are financially unsophisticated. Our work demonstrates that planning behavior can explain the differences in savings and why some people arrive close to retirement with very little or no wealth. This is only one of the disturbing consequences of financial illiteracy. Consumers with low literacy are also less likely to participate in the stock market, and they are more likely to have problems paying off debt.
Our work has also evaluated the role and effects of financial education programs. Most large firms, particularly those offering Defined Contribution pensions, offer some form of education program. The evidence to date on the effectiveness of these programs is very mixed. In our work, we find that seminars do affect wealth holdings. Estimated effects are sizable, especially for the least wealthy. Moreover, we have argued that it is not surprising that one retirement seminar may change behavior only modestly. The few available studies of the topic indicate how many seminars were offered or how many participants attended; in general, participants appear to attend only once or a handful of times. It is unlikely that widespread financial illiteracy will be “cured” by a one-time benefit fair or a single seminar on financial economics. This is not because financial education is ineffective, but because these programs are too small with respect to the size of the problem they are trying to address.
Our efforts to examine the causes and consequences of financial illiteracy have also been extended to datasets beyond the Health and Retirement Study permitting us to assess financial literacy and financial sophistication for many different groups U.S. respondents. For instance, with our cooperation, our questions on financial literacy have been incorporated into the National Longitudinal Survey of Youth and the Rand American Life Panel. We have also been successful in getting several European institutions to add similar questions to household surveys in their own countries. For example, a recent Italian Survey on Household Income and Wealth included some of these questions, and I have worked with the Dutch Central Bank to design questions to measure both financial literacy and financial sophistication in the Netherlands.
I have organized and continue to design new conferences that explore ways to increase the effectiveness of financial education programs. One very influential conference was held at Dartmouth College in October 2005 (www.dartmouth.edu/~lusardiworkshop/ ) and a second at the NBER in Cambridge MA in May 2008 (www.dartmouth.edu/~conference2007/index.htm). These two conferences brought together practitioners, policymakers, and academics from economics, psychology, and marketing. By examining data from newly available surveys and combining knowledge and experience from different fields, the conferences sought to develop new methods and strategies to improve employer-provided financial education programs. Information and insights from these conferences are described in the book that I am publishing this year and that compiles contributions of some of the most highly regarded experts in the fields of financial education, savings, pensions, insurance, and portfolio choice. This book, entitled Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs, examines not only the experience of the United States but also the experience of other countries, such as Sweden, Chile, and OECD nations. It is forthcoming from the University of Chicago Press.
Key Publications
The complete list of my publications and working papers appears in my CV posted on my web page. Some of publications that have been most influential include:
• My paper “Saving and the Effectiveness of Financial Education” was published in the book Pension Design and Structure: New Lessons from Behavioral Finance, eds Olivia Mitchell and Stephen Utkus (Oxford University Press, 2004). It was later reprinted in the Journal of Financial Transformation, vol. 15, December 2005.
• My study joint with Olivia Mitchell “Baby Boomer Retirement Security: The Role of Planning, Financial Literacy, and Housing Wealth,” appeared in the Journal of Monetary Economics in January 2007. This paper was awarded the Fidelity Pyramid Prize, a $50,000 award given to authors of research that best helps address the goal of improving lifelong financial well-being for Americans.
• The paper joint with Olivia Mitchell “Planning and Financial Literacy: How Do Women Fare?” appeared in the American Economic Review. It documents the very low level of financial literacy among older women in the United States.
• My paper joint with Peter Tufano “Debt Literacy, Financial Experience, and Overindebtness” has been widely cited in the press because it documents a strong relationship between financial illiteracy and debt problems.
And the effort will continue. More on the next blog!
Let me start this initiative by summarizing as briefly as possible what I have done so far. My work will continue from here.
In collaboration with Olivia Mitchell from the Wharton School, I have documented an alarmingly low level of financial literacy among older people in the United States. In our sample of older respondents from the Health and Retirement Study, we find that over half of respondents cannot undertake a simple calculation regarding interest rates over a 5-year period and do not know the difference between nominal and real interest rates. An even larger percentage of respondents do not know whether or not a single company stock is riskier than a stock mutual fund. We have also shown that financial illiteracy is related to the inability to devise and implement financial plans. That is, one reason people fail to plan is because they are financially unsophisticated. Our work demonstrates that planning behavior can explain the differences in savings and why some people arrive close to retirement with very little or no wealth. This is only one of the disturbing consequences of financial illiteracy. Consumers with low literacy are also less likely to participate in the stock market, and they are more likely to have problems paying off debt.
Our work has also evaluated the role and effects of financial education programs. Most large firms, particularly those offering Defined Contribution pensions, offer some form of education program. The evidence to date on the effectiveness of these programs is very mixed. In our work, we find that seminars do affect wealth holdings. Estimated effects are sizable, especially for the least wealthy. Moreover, we have argued that it is not surprising that one retirement seminar may change behavior only modestly. The few available studies of the topic indicate how many seminars were offered or how many participants attended; in general, participants appear to attend only once or a handful of times. It is unlikely that widespread financial illiteracy will be “cured” by a one-time benefit fair or a single seminar on financial economics. This is not because financial education is ineffective, but because these programs are too small with respect to the size of the problem they are trying to address.
Our efforts to examine the causes and consequences of financial illiteracy have also been extended to datasets beyond the Health and Retirement Study permitting us to assess financial literacy and financial sophistication for many different groups U.S. respondents. For instance, with our cooperation, our questions on financial literacy have been incorporated into the National Longitudinal Survey of Youth and the Rand American Life Panel. We have also been successful in getting several European institutions to add similar questions to household surveys in their own countries. For example, a recent Italian Survey on Household Income and Wealth included some of these questions, and I have worked with the Dutch Central Bank to design questions to measure both financial literacy and financial sophistication in the Netherlands.
I have organized and continue to design new conferences that explore ways to increase the effectiveness of financial education programs. One very influential conference was held at Dartmouth College in October 2005 (www.dartmouth.edu/~lusardiworkshop/ ) and a second at the NBER in Cambridge MA in May 2008 (www.dartmouth.edu/~conference2007/index.htm). These two conferences brought together practitioners, policymakers, and academics from economics, psychology, and marketing. By examining data from newly available surveys and combining knowledge and experience from different fields, the conferences sought to develop new methods and strategies to improve employer-provided financial education programs. Information and insights from these conferences are described in the book that I am publishing this year and that compiles contributions of some of the most highly regarded experts in the fields of financial education, savings, pensions, insurance, and portfolio choice. This book, entitled Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs, examines not only the experience of the United States but also the experience of other countries, such as Sweden, Chile, and OECD nations. It is forthcoming from the University of Chicago Press.
Key Publications
The complete list of my publications and working papers appears in my CV posted on my web page. Some of publications that have been most influential include:
• My paper “Saving and the Effectiveness of Financial Education” was published in the book Pension Design and Structure: New Lessons from Behavioral Finance, eds Olivia Mitchell and Stephen Utkus (Oxford University Press, 2004). It was later reprinted in the Journal of Financial Transformation, vol. 15, December 2005.
• My study joint with Olivia Mitchell “Baby Boomer Retirement Security: The Role of Planning, Financial Literacy, and Housing Wealth,” appeared in the Journal of Monetary Economics in January 2007. This paper was awarded the Fidelity Pyramid Prize, a $50,000 award given to authors of research that best helps address the goal of improving lifelong financial well-being for Americans.
• The paper joint with Olivia Mitchell “Planning and Financial Literacy: How Do Women Fare?” appeared in the American Economic Review. It documents the very low level of financial literacy among older women in the United States.
• My paper joint with Peter Tufano “Debt Literacy, Financial Experience, and Overindebtness” has been widely cited in the press because it documents a strong relationship between financial illiteracy and debt problems.
And the effort will continue. More on the next blog!
Friday, 20 June 2008
In Favor of Financial Literacy Education
Recent papers are arguing that it is futile to undertake financial literacy education. I do not share that view and let me make just a few simple comments in favor of financial literacy education.
One of the problems of scholars who review the literature on financial education without having done empirical work on this topic or touched the data is that they are likely to miss the large differences that exist in financial behavior. For example, in my work I found that financial education programs do not affect the 'average' household but they do affect those at the bottom of the wealth distribution and those with low educational attainment. These are the groups that financial education programs should reach, but the evidence would not have been found if one were to look simply at averages and to run simple regressions. Moreover, having spent the last six years measuring and looking at financial literacy data, I am concerned about how much we can expect the current financial education program to be effective given they often entail only one-hour of financial education. Small intervention of this magnitude cannot be expected to do much to combat widespread illiteracy. However, this does not mean we should not do any financial education at all.
The vast evidence from psychology that people suffer from biases in their decision-making is sobering and humbling. However, if taken at face value, it seems that people are truly inept and cannot make choice, in fact any choice, not just financial decisions. However, one of the features of the current environment is that people are confronted and required to make choices. People are confronted with a myriad of choices now. For example, they are increasingly asked to decide about the medical treatment to go through and have to be wary of doctors who tend to suggest expensive but unnecessary treatments. There is wide regional disparity on how hospitals treat the same medical condition and people would want to decide in which hospital they want to be treated. If people want to buy cereals, they have a full isle with more than 100 brands to choose from. If they want to buy a cell phone service, they have many features to consider. Should we regulate how people consume? They are likely to make lots of mistakes in that area too.
Continuing on the previous point, how do we deal with the increase in financial responsibility that people are required to take on? Financial literacy education is in my view one of the ways we can help people (and clearly not the only way we should limit to).
There is no obvious alternatives to financial literacy education. The idea is not to transform each person into a financial wizard, but to give him/her the tools to navigate the current financial system. The metaphor that I have used in my work is to have knowledge similar to having a "financial driving license": people drive car without being engineers and they do not need to know everything about cars and driving to be behind the wheels. Even with knowledge, accidents will occur, but this does not mean that it is much preferable to close down the roads that are more dangerous than to allow people to do their own driving.
One of the problems of scholars who review the literature on financial education without having done empirical work on this topic or touched the data is that they are likely to miss the large differences that exist in financial behavior. For example, in my work I found that financial education programs do not affect the 'average' household but they do affect those at the bottom of the wealth distribution and those with low educational attainment. These are the groups that financial education programs should reach, but the evidence would not have been found if one were to look simply at averages and to run simple regressions. Moreover, having spent the last six years measuring and looking at financial literacy data, I am concerned about how much we can expect the current financial education program to be effective given they often entail only one-hour of financial education. Small intervention of this magnitude cannot be expected to do much to combat widespread illiteracy. However, this does not mean we should not do any financial education at all.
The vast evidence from psychology that people suffer from biases in their decision-making is sobering and humbling. However, if taken at face value, it seems that people are truly inept and cannot make choice, in fact any choice, not just financial decisions. However, one of the features of the current environment is that people are confronted and required to make choices. People are confronted with a myriad of choices now. For example, they are increasingly asked to decide about the medical treatment to go through and have to be wary of doctors who tend to suggest expensive but unnecessary treatments. There is wide regional disparity on how hospitals treat the same medical condition and people would want to decide in which hospital they want to be treated. If people want to buy cereals, they have a full isle with more than 100 brands to choose from. If they want to buy a cell phone service, they have many features to consider. Should we regulate how people consume? They are likely to make lots of mistakes in that area too.
Continuing on the previous point, how do we deal with the increase in financial responsibility that people are required to take on? Financial literacy education is in my view one of the ways we can help people (and clearly not the only way we should limit to).
There is no obvious alternatives to financial literacy education. The idea is not to transform each person into a financial wizard, but to give him/her the tools to navigate the current financial system. The metaphor that I have used in my work is to have knowledge similar to having a "financial driving license": people drive car without being engineers and they do not need to know everything about cars and driving to be behind the wheels. Even with knowledge, accidents will occur, but this does not mean that it is much preferable to close down the roads that are more dangerous than to allow people to do their own driving.
Wednesday, 4 June 2008
Consumer Information: Is It Enough?
The Federal Trade Commission (FTC) hosted a conference on Consumer Information and the Mortgage Market on May 29, 2008. You can access the program at:
http://www.ftc.gov/be/workshops/mortgage/index.shtml
and also watch some it on CSPAN
http://www.c-spanarchives.org/library/cache/ASX_205746-2-0-0.asx
FTC certainly deserves credit for organizing such a conference. There was a lot of discussion about how to inform consumers and I came away from the conference pretty convinced that information alone is not enough. We need not only to find ways to communicate in an effective way, but also to simplify information. Some ideas proposed by the speakers were rather intriguing. If we look at other fields—and health is one recurrent example— we have put labels on many food items to make sure people make good decisions when they go shopping. More than this type of information, I like “rating” systems. For example, we use a star system to evaluate safety of cars. While this is not so easy when considering financial products (but Morningstar does it for mutual funds), I think it is important to think of ways not just to provide information but also to process that information and deliver it in a simple and intuitive manner. Two researchers from Vanguard, Gary Mottola and Steve Utkus, have done something similar for the classification of portfolios: they have used a stop-light system: red, yellow and green to classify portfolios. Red is a stop sign, it signals investors they need to stop and reconsider their portfolio; yellow indicates there are problems although not as severe as in the “red light” case. And green means that investors can continue cruising with the current portfolio allocation. In my view, that is a brilliant idea and it is worth a thousand statistics. We have to look for such easy ways to provide information. Note this is not simply information, there is some “mild” advice in it: Red means “stop.” I like that too as I believe this is what consumers are looking for.
http://www.ftc.gov/be/workshops/mortgage/index.shtml
and also watch some it on CSPAN
http://www.c-spanarchives.org/library/cache/ASX_205746-2-0-0.asx
FTC certainly deserves credit for organizing such a conference. There was a lot of discussion about how to inform consumers and I came away from the conference pretty convinced that information alone is not enough. We need not only to find ways to communicate in an effective way, but also to simplify information. Some ideas proposed by the speakers were rather intriguing. If we look at other fields—and health is one recurrent example— we have put labels on many food items to make sure people make good decisions when they go shopping. More than this type of information, I like “rating” systems. For example, we use a star system to evaluate safety of cars. While this is not so easy when considering financial products (but Morningstar does it for mutual funds), I think it is important to think of ways not just to provide information but also to process that information and deliver it in a simple and intuitive manner. Two researchers from Vanguard, Gary Mottola and Steve Utkus, have done something similar for the classification of portfolios: they have used a stop-light system: red, yellow and green to classify portfolios. Red is a stop sign, it signals investors they need to stop and reconsider their portfolio; yellow indicates there are problems although not as severe as in the “red light” case. And green means that investors can continue cruising with the current portfolio allocation. In my view, that is a brilliant idea and it is worth a thousand statistics. We have to look for such easy ways to provide information. Note this is not simply information, there is some “mild” advice in it: Red means “stop.” I like that too as I believe this is what consumers are looking for.
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