Wednesday, April 09, 2008

Financial Literacy

OK, one more rant on personal finance and then I'll stop. Maybe.

Newsweek published an article called Clues for the Clueless about trying to improve financial literacy in America. The article opens with this question:
It is, or at least it should be, a simple question. You have $200 in an investment that's earning 10% a year. Assuming you let the money grow, how much would you have at the end of two years?

Here's how American adults answered that question:

  • 18% said $242.

  • 34% said $240.

  • 48% had no clue.

Extrapolating from those results:

  • Fewer than 1 in 5 adults grasp the basic principles of compound interest. In terms of financial "literacy" we can assume that this group can at least read street signs and newspaper articles.

  • 1 in 3 understand how to calculate simple interest, but they don't understand that there's a difference between simple and compound interest. This group has learned the alphabet, and maybe they can work their way through Dr. Seuss books.

  • Roughly half of all American adults don't understand simple OR compound interest. They don't understand sales tax, let alone credit cards and mortgages. Financially, they're completely illiterate.

And we wonder why our country is having economic problems? Who would ever suspect that big companies might try to take advantage of an ignorant group of consumers like this? Big companies always act in the best interests of their customers. Because that's their job, right?

Oh, wait, I forgot... The primary responsibility of big companies is actually to return huge profits to their investors. And investors really don't care what happens to customers, as long as people keep buying what the company is selling. It reminds me of the line from Casablanca: "I'm shocked, shocked to find that gambling is going on in here!" "Here are your winnings, sir." "Oh, thank you very much."

The problem with the system is that regulators assumed that banks would want to protect themselves and act in their own long-term self-interest. But corporations generally set up employee metrics that reward short-term behaviors, and people generally figure out ways to achieve their metrics. (i.e. People do what you pay them to do. That's the double-edged sword of metrics.) In this case, individuals within the banks recognized that they could best advance their careers by creating complicated, high-risk mortgages and bundling them as securities, and they also realized that they would be promoted and out-of-sight by the time the long-term effects came back home to roost.

SIDEBAR: Speaking of "creative" financing... We have an acquaintance who has recently gotten into the consumer finance industry. He mostly works with people who are on the verge of bankruptcy due to credit card debt and/or "unconventional" mortgages. Recently, he was telling us about a potential client who had a less-than-interest-only mortgage. Here's how it worked:
The guy bought a house for $280,000 with essentially no down-payment. He pays the bank something like $2,000 per month, which is actually less than the interest being accrued on the loan. At the end of 30 years, he has to make a "balloon payment" to the bank of $320,000.

Does it make any sense to deliberately create a situation where someone is perpetually upside-down on a 30-year mortgage? (Yes, the house will probably be worth much more than $320,000 at the end of 30 years, but he's still going to be in serious trouble if he tries to sell the house after only 5 years.) How is it even a mortgage? It looks suspiciously like a love child begotten when Luxury Rental Property went out slumming and had a one-night stand with Payday Loans.

So anyway, back to the Newsweek article...
Financial pros have fretted for decades over our ignorance about money. It's not that Americans' financial knowledge has declined, but that the need for it has increased. Until 30 years ago, people shopped mostly with cash, relied on company pensions for retirement and bought houses using fixed-rate mortgages. Today's world of credit cards, 401(k)s and exotic mortgages require more-sophisticated consumers, but there are few mechanisms to aid this transformation. Some high schools offer courses that teach students how to balance a checkbook or follow the stock market, but only 18 states require personal-finance instruction, and some principals resist adding the topic to schedules already crowded with really useful classes, like trigonometry.

I'm an engineer, so yeah, I actually do think that trigonometry is useful. I also think that American high schools need to be pushing more math, not just making substitutions, if we hope to compete with the rest of the developing world. But in the grand scheme of things, I do believe that a class in personal finance is more important than trigonometry or pre-calculus for the vast majority of high school students, especially for students who hate math and don't plan on pursuing any sort of higher education. I've said it before, and I'll say it again, "If you don't understand math, people will cheat you and take advantage of you. And you won't even know that they're doing it. You'll just know that you're always broke, and you always will be."

Here's the next frustrating bit from the article...
Class and culture also play a role in financial-phobia. When Laureen Hudson, a 39-year-old technical editor, ponders why so many of her friends are clueless about money, she recalls how her crowd of left-leaning humanities and science majors held particular disdain for business students, who always had their noses in The Wall Street Journal. "It's considered noble to ignore money, and it's considered grubby or lesser to concern yourself with finance," she says.

I believe there's a special place in hell for people who choose willful ignorance. (In this case, it's called bankruptcy court.)

I've finished my rant, so I'm going to conclude with this brilliant gestalt from indexed:

As the saying goes, "A picture is worth 1,000 words." Or, in this case, a graph...


Anonymous said...

One of the best explanations of the need to understand financial math I've ever read. The liberal government leaders don't want an informed electorate.

Anonymous said...

Please forward this to Sarah Palin, maybe she will get it on the doc or maybe shoot the principle!