November 7, 2009

Three Reasons Why Financial Literacy Eludes Us

Although I am almost illiterate mathematically, I grasped very early in life that anyone who can count to ten can count upward indefinitely if he is fool enough to do so.
--- Robertson Davies

Yes, we want to make good financial decisions. Yes, we have the capability. However, universal financial literacy remains beyond our grasp for three reasons
  1. trouble reading
  2. trouble perceiving
  3. human frailty
Let's examine them.

Trouble Reading
About one in seven Americans can't read. About 40% of Canadian adults can't read at the level of a high school graduate. Of this group, 15% have serious problems dealing with any printed materials. Maybe they can handle Dr. Seuss, but that won't get them far in life.
Do not worry about your problems with mathematics. I assure you mine are far greater.
--- Albert Einstein
While literacy result are bad, numeracy is even worse. According to the 2003 International Adult Literacy and Skills Survey (IALLS), 55% of Canadians have inadequate math skills. Other countries have issues too. BusinessWeek reports that "Americans are functionally illiterate". The University of Michigan found that only 18% of boomers could solve a simple question involving compound interest. Unfortunately, I can't find that question to share with you.

Even if you're comfortable with words and numbers, you may make the wrong decisions.

Trouble Perceiving
Let's look at snack food and fast food. You're overwhelmed with layers of flavours and sensations: smooth/crunchy, sweet/bitter, hot/cold, hard/soft. This makes food harder to resist. We eat based on the size of the plate. If it's on the plate, we think it'll fit in our bellies. Our bellies expand to accommodate us.

Financial products are hard to compare, which complicates our decisions. What is the cost of a floating rate mortgage compared with a fixed rate mortgage? How much does your credit card really charge you in a year: annual fees, surcharges on exchange rates, interest penalties for late payments? How would this compare with other credit cards? I met someone who pays annual fee of $400 for a credit card because of perceived rewards.

We're better at perceiving change that's linear than geometric. The pattern 1, 2, 3, 4, ... makes more sense than 1, 2, 4, 8, 16, ... but the latter is closer to real life. Compounding interest works for us when saving and against us when borrowing. An interest rate of 1% compounding monthly is higher than 12% a year.

If a mutual fund earns 9% over a year and charges a Management Expense Ratio (MER) of 2%, you'd expect a net return of 7%. You'll get something different because the fund value fluctuates daily and the MER is typically deducted daily a compounding effect).

Try these challenges from earlier posts
Human Frailty
Businesses make money from our weaknesses. Naturally, they propose their products as the solutions. Napoleon Hill identified our six basic fears in 1937 and they're still with us.

Education helps us fight temptation. Discipline keeps us on track.

Financial planning involves immediate pain for long term gain. We feel the pain of saving now but have difficulty visualizing the benefits of secure retirement income decades later. We think we can start saving later, which means we lose the substantial benefits of compounding growth.

Get Smart
Ontario students will learn financial literacy from grades 4-12 starting in 2011. That's great since habits start young. However, we can change at any age. This video from accountants gives helpful basics.



You can also learn from financial bloggers, your advisors and others you trust. You just need the spark of desire to start.

Links
Podcast Episode 42 (5:41)

direct download | Internet Archive page

3 comments:

Anonymous said...

The compound interest question was:

“Let’s say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?”

from:
http://www.mrrc.isr.umich.edu/publications/papers/pdf/wp144.pdf

Promod said...

Thanks for taking the time to share the question. Readers can now test their skills.

Alika said...

Informative post. Good information has been given. Thanks for providing such useful information. It will be very useful for the readers.

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