Did you know that:
- 76% of millennials lack basic financial knowledge.
- Two-thirds of Americans don’t understand basic financial concepts. For example, they can’t compute the interest on a $20,000 loan with a 10 percent interest rate.
- Americans are generally overconfident in their financial knowledge, only a few could score a top grade on a financial quiz. In a survey of 1,200 American adults, 44 percent reported that they are extremely or very financially literate. However, when asked to take a financial quiz, fewer than half passed, and only 6 percent scored an “A” grade of 90 percent or better.
All three stories about Americans’ challenges with financial knowledge appeared within the past month in different media outlets and most of us encounter such bleak articles frequently. The gloomy conclusions reached by observers begs one of the most important personal finance questions of all: What does it mean for a person to be knowledgeable about their finances?
Financial knowledge is treated as synonymous with financial literacy
When financial knowledge is studied by social scientists, most often they are referring to the individual’s financial literacy, which is knowledge about basic personal finance concepts such as interest, compounding, and risk, with respect to borrowing, saving, and investing decisions. Over decades of research, economists and psychologists have found that financial literacy has a modest positive effect on personal finances.
To give you a better sense of this concept, here are three questions from a popular study measuring financial literacy:
1) Considering a long time period (for example 10 or 20 years), which asset described below normally gives the highest return? (A) Savings accounts, (B) Stocks, (C) Bonds, (D) I don’t know.
2) Suppose you had $100 in a savings account and the interest rate is 20% per year and you never withdraw money or interest payments. After 5 years, how much would you have on this account in total? (A) More than $200, (B) Exactly $200, (C) Less than $200, (D) I don’t know.
3) Do you think that the following statement is true or false? “After age 70 1/2, you have to withdraw at least some money from your 401(k) plan or IRA.” (A) True, (B) False, (C) It depends on the type of IRA or 401(k) plan, (D) I don’t know.
The answers are here, here, and here, respectively. However, there’s a lot more to being knowledgeable about personal finances. To make an informed financial decision, most people must know more than basic principles of how finances work.
Financial knowledge is of six qualitatively different, but equally important types
- The broad theory behind the financial decision. For the sake of our discussion, let’s assume the decision is about saving for retirement. To make this decision, factual information of the sort covered by financial literacy questions provides the foundation. An example of this type of knowledge is that diversifying retirement savings by buying a broad range of stocks (e.g., with an index fund) will reduce the person’s risk.
- Deeper category-level information is equally, if not more, important. For instance, you’d want to know what “broad range of stocks” means. What stock categories will be needed for sufficient diversification (e.g., US stocks vs. international stocks)? How many should be purchased? How to allocate across them? Questions of this type of detail are rarely covered in financial knowledge surveys.
- After the investor has clarity about the different types of stock categories, they still need to choose specific options. For instance, once the individual has decided they want to invest their retirement savings in a US-Total Stock market mutual fund, they must still choose which company’s fund to purchase. There are dozens of such choices available. Such knowledge is even more difficult to acquire because it is so comprehensive.
- The fourth type of financial knowledge is procedural information necessary to carry out the financial decision. Simply choosing a particular mutual fund is not enough. The person needs to know the steps they’ll need to open a retirement account, how to deposit money into it for the first time, and then how to add to it in the future. To choose prudently, they’ll also need to know the account’s features and the fees associated with it.
- So far, all the types of financial knowledge had to do with external information. But one thing common to all financial decisions is that the person’s situation is its driving force. What is suitable for one person is totally inappropriate for another. The individual has to be privy what I call personal reference knowledge to make an effective decision. This knowledge has to do with questions such as how much money can I afford to put towards my retirement savings every month, how am I spending my money currently and what can I cut to increase how much I save, and so on.
- And finally, the individual’s personal background knowledge needs to be probed and verbalized. At what age do they want to retire? How much savings will they need? How much are they already saving each month, and how much money have they already saved for retirement? What are their spending habits? How “good with money” are they? Consumer psychologists have studied many of these questions, often finding that this type of knowledge is a function of the individual’s personality.