Monday, June 3, 2013

The Financial Literacy Test

How many of you can get all three of these following questions right (answers at the bottom of the post):

  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:
    1. …more than $102?
    2. …exactly $102?
    3. …less than $102?
    4. 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:
    1. …more than today?
    2. …exactly the same as today?
    3. …less than today?
    4. 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.’
    1. True
    2. False
    3. Do not know

If you got all three correct, congratulations – you’re in a global minority. In a US survey, less than half could answer the first two questions correctly, less than a third were able to answer all three. And this was for people aged 50 and over, who are generally more financially literate than the average population. The same questions have been used in international surveys, and the results are pretty depressing: across the globe, financial literacy is low, and especially low among the young. It doesn’t appear to matter whether you’re in a developed

The questions come from an NBER working paper released about a month back (abstract):

The Economic Importance of Financial Literacy: Theory and Evidence
Annamaria Lusardi, Olivia S. Mitchell

In this paper, we undertake an assessment of the rapidly growing body of research on financial literacy. We start with an overview of theoretical research which casts financial knowledge as a form of investment in human capital. Endogenizing financial knowledge has important implications for welfare as well as policies intended to enhance levels of financial knowledge in the larger population. Next, we draw on recent surveys to establish how much (or how little) people know and identify the least financially savvy population subgroups. This is followed by an examination of the impact of financial literacy on economic decision-making in the United States and elsewhere. While the literature is still growing, conclusions may be drawn about the effects and consequences of financial illiteracy and what works to remedy these gaps. A final section offers thoughts on what remains to be learned if researchers are to better inform theoretical and empirical models as well as public policy.

The paper is really a survey of the current state of research into financial literacy and its wider economic implications. Study after study finds that financial illiteracy is common, and in fact the norm.

Yet literacy in financial matters – especially in an increasingly complex and noisy financial system – and is what I would class as a life skill. I suspect that one reason why wealth inequality is so persistent, is through the uneven distribution of financial literacy.

Generally speaking, higher income (and wealthier) individuals possess greater degrees of financial literacy. There remains the question of causality (does literacy come first, or does greater wealth create the desire for greater literacy?), but there’s hardly anything controversial about investing in knowledge.

If there’s one thing that’s definitely missing from our education system – and from virtually everyone else’s – it’s mandatory financial literacy courses. This should be part of at least the secondary/high school curriculum. As it stands, financial literacy is almost entirely up to the parents, who might not be all that literate either.

[Answers: 1,3,2]

Technical Notes

Lusardi, Annamaria, and Olivia S. Mitchell, "The Economic Importance of Financial Literacy: Theory and Evidence", NBER Working Paper No. 18952, April 2013


  1. This actually supports a long held view of mine that market failure happens when the financially illiterate masses start moving into any particular flavour-of-the-month market. The very entry of the masses pushes the market up, and the fact the market has been pushed up pushes the market up further. The financially illiterate masses don't realise this mechanism, and the price movements are used in hindsight to "prove" the brilliance of their pseudo-logical analyses used to justify their earlier investment. They then pass on their "tested and proven wisdom" to further perpetuate the cycle.

    This all makes the financially literate who counsel caution based on knowledgeable analyses look very wrong (and very stupid), and it's only a matter of time before these too can't stand waiting on the sidelines and begin taking a sip of the kool-aid. Ergo, market failure is doomed to repeat every few years.

    With financial illiteracy being the norm (in the US not least. Wouldn't Malaysia be worse?), shouldn't governments proactively assume that the market is irrational and be more proactive in regulating credit growth and asset price cycles? A useful barometer to avoid over-regulation could be a measure of the rate of change of the ratio of professional v layperson participants in a particular market. When the masses start piling in, it's a sure sign that it's amateur hour, and many of these people don't really know what they're doing.

    1. Spot on, mate. You literally took the words from my mouth. Anyway, substitute 'market' with democracy. Factor in issues/ideological/policy illiteracy into the equation and you will see why democracy failure comes about. The same type of illiteracy that pervades markets also pervades democracy. Only thing, the effects are catastrophic and explains why potential first world countries end up as basket case banana republics. Give the vote to ill informed, plainly stupid and ignorant masses and watch democracy morph into democrazy.

      Warrior 231

    2. Interestingly enough, a similar idea was previously mooted by Lee Kuan Yew, who suggested that people with families be given extra votes to give weight to their greater stake and interest in improving society. This obviously didn't take off.

      Your criticism of democracy is absolutely correct, but there is no viable alternative to "democrazy". Giving somebody the right to restrict the right to vote gives him the right to become a dictator. Quis custodiet ipsos custodes?

      Personally, I feel that a benevolent dictatorship like Singapore's PAP which supplements the right to vote is the most efficient form of government, but getting such a regime in power requires a lot of good fortune. Without democracy, history shows that one is more likely to end up with a incompetent and malevolent dictatorship. The unfortunate fact is that a country made by a majority of illiterates and fools is likely to be led by a government of incompetents and opportunists, whether by way of a forcibly imposed dictatorship or by way of "democrazy".

      To quote Churchill, "Democracy is the worst form of government except for all those others that have been tried."

  2. no 1 like calculate the Present value

  3. No 3 i think Mutual Fund is safer becos the risk is bear..when the stock being diversified, the risk become lower..

  4. @Living Seed, lets redefine mutual funds as they are commonly knowns as outside the US and simply call them unit trusts. By safer return we also want to factor in the cost of the fund, the cost of inflation, and the cost of doing nothing. Mutual funds demand more investing knowledge by the consumer, its not as simple as buying 10000 worth of funds once and sitting on them. Imho, a better bet would be buying a dividend stock and collecting dividends over time if people do just want to sit on stocks. Thats what a lot of average investors do with mutual funds

  5. Q3 is very debatable. Based on Warren Buffet, if you have that one company well, and worth buying, it is much safer than buying the stock mutual fund (or unit trust).

    Zuo De

  6. Sorry, it is "if you know that one company well"

    Zuo De

  7. And from life experience, it is true. Some of the unit trusts did not perform any better than the company that i studied in detail and bought from the share market.

    Zuo De

    1. Zuo De,

      I'm afraid you failed Q3. Unlike Q1 and Q2, this one's a fairly technical question. Safety (lower risk) is not defined as good or bad returns, but the volatility of returns. A diversified portfolio will always offer safer (lower volatility) returns than a single company.

      That's why Buffet still buys lots of companies, not just one, no matter how good that one company is.

    2. A diversified portfolio of different stocks yielding separate dividend streams is not the same as buying into one mutual fund. There are basically 3 types of mutual funds and the more.common ones in malaysia and singapore are unit trusts. One mutual fund witb a basket of.stocks does not give you separate dividend streams. One could get a better and safer return buying stocks in established companies that have sound financials which also offer good dividend streams, in some cases the return from.dividends alone would be higher than the current long term deposit rates that banks offer. An investor who chooses unit trusts.must be familar with dollar cost averaging and he needs to time his purchases buying more.units when the market is down amd less when the market is up. Furthermore, investors need to occasionally reweight the fund, and this option is usually only free the first time. Subsequent attempts to reweight thr fund are usually charged.

      These mechanics are never explained to individuals who to mutual fund. As an experiment I invested 10000 in a mutual 1990, today the value of my fund is less than 9000. I have fared a lot better in 3 years buying 3-4 separate stocks as dividend investments and having a riskier strategy with intraday movements.

      Mutual funds.require a.lot more.research as well and the literature out there does not emphatically state that mutual funds are better.For people like Buffet they would be more keen to see their fund size get larger

    3. Munsterz,

      You appear to be confusing dividends with the degree of safety. That is not correct - it's the volatility of the total return for a given level of return that defines risk.

      I'd love to delve into this further, but I'm off on holiday today and won't be back til next week.

    4. Common sense dictates that the amount of return ultimately generated in a single anecdotal case does not prove anything about the amount of risk assumed to generate that return.

      Let's say I play a game of "coin toss", betting my money on heads. If I throw only once, I have a 50% chance of doubling my money, and a 50% chance of losing everything. This is high volatility. If I throw twice, I have a 25% chance of doubling my money, a 50% chance of breaking even, and only a 25% chance of losing everything. Throwing twice doesn't guarantee me a better result, but it results in lower volatility, i.e. the chance of doubling your money is lower, but the chance of losing everything is also lower.

      In theory therefore, owning 3 good companies is less volatile than owning 1, and owning 10 is less volatile that owning 3. Many people don't mind sacrificing the chance to get higher gains in order to minimize the risk of losing everything as they prefer a "safer return", and this is the key selling point behind mutual funds.

      Ultimately, the key takeaway point is that "safer returns" do not mean "higher return". Instead, it means lower volatility. Indeed, the highest possible return from an "investment" is in a 10 ringgit lottery ticket, but the volatility is through the roof.

      Disclaimer: Armchair spectator speaking. As a freshie, I don't really have the money to plow around in stock selection and mutual funds just yet.

    5. @anon 1.13

      Yup, that's a pretty good summary. Note here that risk also encompasses both "better" and "worse" returns than expected, not just "worse".

  8. Hishamh,

    Have a nice holiday.

    However, noting your explanation on volatility of returns, the example of Buffet buying more and more companies is not correct. My take is he continue to buy companies because he bought one good company that generated so much cash that he has to continue to buy companies to make use of the cash and not he bought the companies to reduce his volatility of return

    Zuo De

    1. Hi Hisham, hope you don't mind me chipping in.

      On a technical basis, Q3 is not debatable because there is no way to have enough information, whether present or future, to predict with absolute certainty how a company will perform into the future. Buffet publicly claims to be a student of the Graham value investing school, and thus Hisham is probably correct.

      If you look at the history of the US stock market, you will find that the MAJORITY of huge companies which were considered invincible at some point in their life cycle had crumbled or diminished for one reason or another. Some reasons were knowable, some reasons were not (e.g. an unpredictable crisis that affects the particular industry. Think about Bear Stearns or Lehman Bros) Even a company with great management and sound financials may suffer greatly if one risky bet goes wrong.

      What Buffet aims to achieve is not the absolute maximum possible returns (the aim of speculators worldwide), in which case he just needs to put as much money as possible in the best company, the balance in the 2nd best company, the balance from that in the 3rd best and so on. Instead, he aims to achieve both maximum returns and minimum volatility of returns at the same time, in which case he buys a spread of the top performing companies in different industries, and in different countries, in different currencies etc in order to diversify his risk. He also tends to put the majority of his money in large cap, established companies in stable industries (F&B, supermarkets and retail banks) with a good history of paying dividends as these companies have less volatility of returns.

  9. Very good..

    How about this question:

    A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. How much does the ball cost?