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Is financial literacy good?

February 5, 2012

 Think you are financially savvy?  Take this quick quiz:

Question No. 1: If you save $100 in a savings account with two percent interest that compounds annually, after five years would you have:

A. Less than $110

B. Exactly $110

C.  More than $110

Question No. 2: If you save $100 in a savings account with one percent interest a year the same time inflation is at two percent a year, after one year, would you be able to buy:

A. $100 worth of goods and services at the initial value

B. More than $100 worth of goods and services at the initial value

C.  Less than $100 worth of goods and services at the initial value

Question No. 3: True or false — investing in one company’s stock is statistically safer than investing into a mutual fund that invests in many different stocks.

Here are the answers:

No. 1: C. More than $110.  After the first year, you would have $102, and then earn two percent on this, which would be $2.04, and that would give you $104.04. Two percent of this would be $2.08, which would give you $106.12. Two percent of this amount is $2.12, which would yield $108.24, and two percent of that amount is $2.16. In all, you would have $110.40, slightly more than $110.00.

No. 2: Also C. After one year, you would have $101 saved. The average price of most goods and services of the original $100 would be $102, meaning the original $100 would only be able to buy $99.02 worth of goods and services.

No. 3: False. Statistically, owning multiple stocks is the safer investment. While the price of one stock can grow substantially in a year, it also can decrease substantially. If you own a stock in a company that goes bankrupt, you will lose your entire investment. When you purchase a mutual fund, there is a better chance that even if one stock goes bankrupt, the others will not, which gives you more security.

When these three quiz questions were given to a random sample of individuals aged 50 and older in a retirement and health survey, only 50 percent were able to get questions 1 and 2 correct, while only 33 percent answered all three questions right. These are the people who should know the most about personal finance, but still struggle with some of the basic concepts of compound interest, inflation and diversifying investments.

Traditionally, the answer to improve this has been to have more financial literacy taught in schools. It stands to reason that more education will create smarter consumers. The problem is, this generally isn’t very efficient.

Research compiled by the Federal Reserve and Professor Lauren Willis shows some of the drawbacks of financial literacy. Willis’s paper The Financial Education Fallacy points out some of the problems with financial education. First, the complexity of the products ranging from mortgages to investments continues to increase, and with the current dismal state of financial literacy, the education would have to be extensive. Second, many would not be interested. When one credit card company offered free financial education to thousands of at-risk borrowers, only .03 percent — three out of 10,000 people — completed the course.

Another reason financial literacy can be problematic is that no matter how much education is available, the marketing of complex products is usually more effective than the education. When consumer advocate groups tried to warn consumers about the dangers of new types of mortgages in the early and mid-2000s, mortgage firms were able to increase their marketing to drown out the educational messages. Finally, most poor decisions in personal finances come from psychological factors, and this is a very difficult subject to teach.

I am not in total agreement with Willis, but I do think people have a couple of choices. One, if you want to handle your personal finances yourself, you need to educate yourself and continue to learn throughout your life. If you are diligent and willing ,I think you can follow some simple rules to be successful with your own personal finances.

If you do not enjoy personal finance or do not want to educate yourself, you still can be successful if you find an unbiased, professional advisor. He or she should be an expert who is able to look at your situation and give you advice on what is best for you, not what gives him or her the highest commission. For those of you who are better at making money than spending money, this might be the best choice for your financial success.

You have an important choice to make. Are you going to take the time to continue to educate yourself about personal finance? Or do you want to find a professional advisor to help you out? Either can work, but do a little of both or neither, and you likely will run into some personal finance difficulties down the road.

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