The Importance of Financial Literacy

Abstract

How much do individuals know? Increasingly, individuals are in charge of securing their own financial well-being after retirement. With the shift from defined benefit to defined contribution pensions, today's workers must decide both how much to save and how to allocate their retirement wealth. Financial markets have become more complex and individuals are faced with a proliferation of new investment products. Investment opportunities have expanded beyond national borders, permitting individuals to invest in a broad range of assets and currencies. However, as the financial crisis has made clear, it is very hard to navigate this new financial system, and the consequences of mistakes can be devastating. How well equipped are individuals to make financial decisions and how much do individuals know about economics and finance? Very few datasets provide information about financial literacy, and those that do often do not have any facts about saving and financial decisionmaking. To address this, Olivia Mitchell and I designed a module on financial literacy for the Health and Retirement Study (HRS), a survey that provides information on people 50 and older. (1) We aimed to assess their knowledge of basic concepts that lay at the basis of saving and portfoliochoice decisions, such as interest compounding, inflation, and risk diversification. The results from that initial module were striking: only one-third of respondents could do simple inter est rate calculations and appeared to understand the effects of inflation and the workings of risk diversification. What is surprising is not that people lack financial knowledge, but rather how little people know about basic economic concepts. Financial illiteracy is not only widespread but is particularly severe in certain demographic groups. Two groups that stand out from our analysis are the elderly and women; both of them display very low knowledge. (2) These findings are not unique to this survey or to this particular age group. We have confirmed these findings using different datasets, different methods of data collection, and different age groups. For example, we find low rates of numeracy among younger individuals (Early Baby Boomers) (3) and in the entire U.S. population. (4) Moreover, such results are not limited to the United States. With several co-authors, I examined financial literacy in the Netherlands using the same questions that I used in the U.S. HRS. (5) Like American households, Dutch households also exhibit fairly low levels of financial knowledge. (6) Together with Peter Tufano, I also have assessed financial knowledge that is specifically related to debt, or debt literacy. (7) Our aim was to evaluate respondents' knowledge of the workings of interest compounding and credit cards and their ability to compare borrowing options and choose those with lower rates. We found that even though most individuals deal frequently with credit cards and other forms of borrowing, only a minority of individuals in the United States possess basic financial knowledge relating to debt. For example, only one-third of respondents in a representative sample of the U.S. pop ulation know that they cannot eliminate credit card debt by paying a minimum amount equivalent to the interest payments. In this survey, we were able to go one step further in our analysis to compare actual financial knowledge (as determined by responses to our debt-literacy questions) to self-assessed knowledge, which was determined by asking respondents to rate their own financial knowledge. In stark contrast to responses to the questions measuring actual knowledge, the majority of individuals give themselves high knowledge ratings, pointing to a gulf between how much people actually know and how much they think they know. Two other findings stand out in our analysis: we find that women display low debt literacy, based on responses to our questions measuring actual financial knowledge, and that they give themselves low ratings when assessing their own financial knowledge. …

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