Why Did Financial Literacy Take A Nosedive?

Readers, I am catching up a bit on news items I missed while I was on vacation, and here’s a headline from MarketWatch, about two weeks ago:  “Financial literacy skills have taken a nose dive since the Great Recession.”  The surprising state of affairs is that, with respect to a triennial survey of financial well-being and financial literacy, while oldsters (age 55 and up) remained stable in their financial literacy quiz scores, the young ‘uns saw a dramatic drop.

What’s going on?

The National Financial Capability Study asks 6 questions related to financial knowledge.  For evaluating changes in answers over time, the study authors excluded the sixth, which only entered the survey in 2015.  Looking at those survey respondents who got at least four out of five questions correct,

  • Of those ages 55 and older, the percentage dropped from 51% to 48%.
  • Of those between ages 35 – 54, the percentage dropped from 45% to 33% — so, 12 percentage points or a 27% drop.
  • Of those between ages 18 – 34, a drop from 30% to 17% — 13 percentage points or a 43% drop.

(Of note, the pattern was relatively steady over the three intervals, and there is no data prior to 2009.)

The MarketWatch article, based in part on the observations of Gerri Walsh, president of the FINRA Investor Education Foundation, speculates that there may be multiple causes, from cuts in school budgets effecting general literacy and numeracy of adults who were still in school in the immediate post-recession period, to the fading relevance and awareness of inflation to the impact of smartphones and a “just look it up” culture.

So what were the questions?  Would you be able to answer them?  The survey report provides the trends in what percentage of people successfully answered them, though not broken down by age group.

Question 1 asks about basic understanding of interest accumulation:  if you have $100 in a savings account with 2% interest, after 5 years, would you have more than, less than, or exactly $102?

Question 2 asks about inflation:  if you have an interest rate of 1% and inflation is 2%, how much is your savings account money really worth at the end of a year (would you be able to buy more, less, or the same amount as today)?

Question 3 asks:  “if interest rates rise, what will typically happen to bond prices?”

Question 4: if you have a loan with 20% compounded interest, and you never make any payments, how quickly will the amount owed double? — with choices given at intervals of 2, 5 and 10 years.  (Note that this question was not in the 2009 survey.)

Question 5:  will you pay less interest over the life of the loan on a 15 or 30 year mortgage?

Question 6:  is it safer to buy a single company’s stock or a stock mutual fund?

Now, happily enough, the folks at FINRA who sponsor the study also make available the data itself, conveniently downloadable.  What follows are some thoughts based on some Fun With Pivot Tables and attempts to intuit some insights based on common sense.

In the analysis that follows, it’s important to understand that I have not done any of the statistical significance tests that would be necessary to come to definitive conclusions.  In addition, the published survey results have slightly different values, which are the result of the report’s method of weighting individual survey responses to reflect the degree to which the survey respondents did not match the characteristics of the American population in general, a set of calculations which I did not undertake for simplicity’s sake.  These comments should be understood as providing some thoughts and ideas only.

Given the caveat above, here’s a breakdown of the percentage of survey-takers who answered each quiz question correctly, by age, for 2009 and 2018.

Financial Literacy quiz results, 2009 – 2018

own data analysis; source data at http://www.usfinancialcapability.org/downloads.php

Note that the “relative change” is the percent of people in that age group who answered the question correctly in 2018 relative to 2009, so the lower the number, the larger the drop in knowledge for that question.  However, the overall context also matters:  how important is the 29% drop in 35 – 44 year olds knowing about relative movements in bond prices, if only 30% understood this concept in 2009 in the first place?

And I doubt it’s of much surprise that the bond price question had the fewest correct answers, or that older people are more likely to answer it correctly, once they start actually investing in bond funds personally, either directly or in their 401(k).  I’ll be honest:  I doubt that understanding bond prices is a key ingredient in financial literacy in any case, and, in any event, that’s knowledge that can be learned independently once it becomes relevant, upon both having money to invest and reaching the age at which more conservative investments are required.  It’s also less relevant now than in the past, because so many of us with 401(k) plans simply invest in the “target date funds” our employers select for us without feeling the need to understand the details.

In the same fashion, substantially fewer young and young-ish adults understand the importance of diversification in investments, and the benefits of choosing a mutual fund over an investment in a single stock.  Does this matter?  I would suspect that a growing number of investors don’t know what a mutual fund is, not for the “old-fashioned” reason that they buy specific stocks, but because, again, they choose their employer’s 401(k) default option and may not even understand that the name for this sort of fund is mutual fund.

Finally, again, young-ish adults had a significant drop-off in their ability to understand inflation.  Interestingly, while fewer of the youngest age group gave the correct answer than for any other age group, their relative drop-off was less than for the older 25 – 44 year old groups.  One might guess that lived experience of inflation is declining (though still increases with age, simply because of an awareness that prices have indeed increased since one’s youth) but that there remains a core knowledge base through direct financial instruction in schools, which is increasing as more states implement mandates.

And, finally, the missing column in this table is the question 4, above, on compound interest.  This is the key concept for which the failure to understand this is at the heart of so many Americans’ financial woes, when they simply do not grasp the depth of the consequences of high-interest loans, and it is unfortunate that it was not included in the 2009 survey for comparison.

The answer to the question, for any readers who are themselves unsure, is this:

At the end of year 1, your debt on a $1,000 year loan at 20% interest increases to $1,200.  At the end of year 2, you owe $1,440.  At the end of year 3, you owe $1,728.  And at the end of year 4, you owe $2,074 — so the answer is “at least 2 years but less than 5 years,” as 31% of survey-takers said.  But a further 29% said, “at least 5 years but less than 10 years,” and, to be honest, it’s not so egregiously wrong to say this, since it’s a bit of a nit-pick as to whether it’s at the end of year 4 or the beginning of year 5, and I might have phrased the question differently or set different answer choices so as to separate out those who clearly had no understanding.

And, as it turns out, with respect to this question, there is virtually no age difference in terms of the proportion of survey-takers giving the correct answer — all age groups answered correctly at rates between 30% and 33%.

So what’s the bottom line?

We don’t need to panic at these survey results, certainly.  Some of the information is acquired by lived experience and becomes more relevant as one ages.  What matters most is understanding how costly personal debt can be, and having the ability to avoid it (both in terms of financial skills and temperament as well as income), which is a whole ‘nother can of worms.

What do you think?  Share your thoughts at JaneTheActuary.com!

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