We all make financial decisions in our everyday life, both big and small. But being familiar doesn’t necessarily make us experts on the topic. The fact of the matter is that managing your money and making sound financial decisions is difficult. Financial decision making is a complex beast and a full understanding of it might require much more than familiarity.
Examining financial literacy
Let’s begin with measuring your knowledge in one of the key areas of financial decision-making. Do you think the following statement is true or false: “Buying a single company stock usually provides a safer return than a stock mutual fund.”?
If you said single stock is riskier than mutual fund, you would be right. If you said you don’t know or single stock is safer than mutual fund, you are not alone. Only 52% of the respondents from a representative U.S. sample gave the correct answer to this question while 34% of them stated they do not know the answer.
This finding is not unique to the US. Although there is large variation in the percentage of participants who answered this question correctly across countries, the low percentage of correct answers is persistent. Only 14% of the Romanians, 39.5% of Japanese and 52% of Dutch answered this question correctly. The percentage of correct answers was 68% even for Swedes. This is low given that Sweden is considered as one of the most financial-savvy countries. The pattern we observe here is not unique to the risk related questions. Participants seem not to know about other financial topics such as interest rates and inflation either.
The conclusions drawn from these studies are (1) financial literacy, “the ability to use knowledge and skills to manage one’s financial resources effectively for lifetime financial security”, is low all around the world and (2) financial literacy needs to be improved in order to promote optimal financial decision-making.
How important is improving financial literacy?
The tendency has been to accept increasing financial literacy as the solution to sub-optimal financial decisions, but should we be so fast to place so much emphasis on bettering financial literacy? Think for a second about the conclusion #2. Is it is really necessary to improve financial literacy for bettie decisions? The argument could be made that increasing financial literacy via education might not be necessary for making better decisions. If you don’t know much about financial topics, getting education is not the only path to improve your decisions. You can hire a financial advisor or you can consult a friend who is competent on financial topics.
Second, it is not clear that increasing financial literacy is sufficient for making better decisions. An intervention can be quite effective at increasing financial literacy. But it might not improve financial behavior in the intended way, or even worse, it might affect it negatively. After all, gamblers know the odds are always in favor of the house, but this does not stop them from believing that they can be an exception to this rule.
Looking at the research behind financial literacy
Is improving financial literacy necessary for improving financial decisions, or might simple communication be enough?
In a lab experiment, Ambuehl, Bernheim, Ersoy and Harris (2017) showed that financial education might not be necessary for making better financial decisions. In this experiment, participants first answer a set of compound interest questions by themselves. Then, one group of participants, let’s call them “communication group”, are randomly paired with each other. They discuss how they would answer a set of compound interest questions. The pairs discuss the problems as much as they want but they do not jointly answer the questions. Another group of participants, the “contemplation group”, receive the exact same questions. They work on answering these questions by themselves. Keep in mind neither of these groups has been given financial education. After, the communication/contemplation, participants again individually answer some compound interest questions.
Communication groups did better than the contemplation group. This is evidence for that financial education might not always be necessary to achieve better financial decision-making. Communication might be just enough. Furthermore, pairs in which both parties are struggling benefit the most from communication. This indicates the importance of communication.
If improving financial literacy is not necessary for improving financial decisions, is it at least sufficient?
In another recent paper exploring this issue, Ambuehl, Bernheim and Lusardi (2017) show that a financial education intervention is effective at increasing financial literacy but it does not help people make better decisions, on average. In their lab experiment, some participants receive an education module on compound interest. Let’s call this group the “education group”. The education module included both rules of thumbs on how to do compound interest calculations and motivational rhetoric such as Einstein’s famous quote of “compound interest is the most important force in the universe”. Other participants received an education module on an irrelevant topic. This is the “no-education group”. After the modules, participants make some decisions involving compound interest. Then, they also answer some financial literacy questions. The researchers found that some members of education group did substantially better on financial literacy questions than no-education one due to the substantive content of the education module. So far so good, but what is the catch?
Well, it turned out that education did not help participants make better decisions, on average. When all of the participants of the education group were looked at as a whole, it was found that some participants end up making better financial decisions than average due to the education and some make worse decisions than average. So, on average, these effects cancelled out each other and there was no net improvement on quality of financial decisions.
But, why did this happen?
It all came down to Einstein. To figure out why this happened, the researchers had another experimental group that received an education module which had only substance but no motivational rhetoric. They found that there was no change in behavior in this case. So the changes in behavior that were initially observed was due to the motivational rhetoric in the education module. The rhetoric moved all participants in the same direction regardless of their starting point. This was a good thing for the participants who initially undervalued investment opportunities. Conversely, it was a bad thing for the ones who initially overvalued the investment opportunities. Hence, we end up with this surprising result: financial education is not sufficient for better financial decisions.
To wrap up, we all hope to make good financial decisions and want to know more about how to make good decisions. Increasing financial literacy through financial education seems like a reasonable first step. But recent research shows that increasing financial literacy via education is neither necessary nor sufficient to reach this aim. So, we still have a lot to uncover.
Ambuehl, Sandro and Bernheim, B. Douglas and Ersoy, Fulya Y. and Harris, Donna, Social Transmission of Financial Decision Making Skills. A Case of the Blind Leading the Blind? (2017). Rotman School of Management Working Paper No. 2891753.
Ambuehl, Sandro and Bernheim, B. Douglas and Lusardi, Annamaria, The Effect of Financial Education on the Quality of Decision Making (2014). NBER Working Paper No. w20618.
Hastings, Justine S., Madrian, Brigitte C., and Skimmyhorn, William L., Financial Literacy, Financial Education, and Economic Outcomes (2013). Annual Review of Economics, 5, 347-373.
Lusardi, Annamaria and Mitchell, Olivia S., The Economic Importance of Financial Literacy: Theory and Evidence (2014). Journal of Economic Literature, 52(1), 5–44.