Are Americans Financially Illiterate?

Greetings from Sedona…

Recently the National Bureau of Economic Research (NBER) released a report showing that the average person does not have the financial literacy required to navigate the modern economy.  The only positive thing I can say about this exercise in discovering the obvious is that it wasted private and not taxpayer dollars.

The overly negative tone of the NBER report chronicling the financial illiteracy of the American public is actually misplaced.  The fact is that there has been a huge improvement in financial literacy over the last thirty years.  I saw this first hand as a financial professional.  At the beginning of my career in the late 1970’s the average person knew next to nothing.  For example, when a special, temporary, tax free bank certificate of deposit was made available in 1980 many in the stock brokerage industry were concerned that they would lose business to the banks.  Exactly the opposite occurred.  We were astonished at how few people had any idea that you could invest in anything that yielded tax free income.  In other words, our market expanded exponentially overnight.

In 1970 the sum of business coverage was a few seconds on the evening news.  During the 70’s Wall Street Week and the Nightly Business Report were introduced on PBS.  That was it.  In addition, even for the educated, getting comprehensive and timely information was difficult indeed.  Today we have multiple 24/7 networks devoted exclusively to financial news.  Obtaining data is a snap via the Internet.  The effect I observed in the increased education level of the people I encountered was dramatic, and the improvement continues.  The reason is that people will readily learn what they think is in their interest to know as long as they are afforded the opportunity to do so.  It may not happen overnight, but it will happen.

The reflexively chanted, montralike, somber toned response to such revelations is usually that our schools must be enlisted to impart the requisite knowledge to our precious children.  As with all other similar instances this would be exactly the wrong approach, guaranteed to be a waste of time and effort with regard to the vast majority of the students who would snooze through the classes if they were present at all.  Like nearly everything else taught after basic reading and arithmetic, the subject of personal finance is useless because there is nothing for the students to relate to in life that is of any importance to them.

Unfortunately, the futility associated with our elementary/high-school paradigm is the least of the barriers to the public becoming financially literate.  There is the cultural phenomenon of extending childhood well into the twenties.  There can be no expectation of financial literacy when the little animals are segregated from the real world for longer and longer periods, now approaching twenty years in too many cases.

The next factor impeding financial literacy is the cultural ambience of spending being patriotic and necessary for a healthy American economy.  Then there is the nonsense of entitlements along with the knowledge that when you mess up financially there will be little or no painful consequences.  Gosh, until recently everyone was even entitled to own their own home even if they had no money and hardly and income.  By the time our adult sized children take on mortgages and bear children it is too late.  The bad habits are so deeply embedded that all the headlines in the world will have little effect.  Historically, only the macro economic consequences of a bust up depression and massive unemployment get very many people to take notice and get the old time religion of tightwadism.

Part of the blame must also accrue to the financial services industry.  It is the only industry I know that subtracts value from its clients in the aggregate.  Even lawyers are unable to do that.  The reason is that the professionals know next to nothing about their subject.  Once you get past price-earnings and chart patterns, nearly everything they spout is wrong.  The public believes the securities market is a casino for good reason.  The industry acts like croupiers raking the cash from the suckers at the roulette wheel.

The least of it is that the industry will have you all-in at the top of the market and all-out at the bottom when you just can’t take any more pain.  Huge conflict of interest issues have traditionally been at the heart of this phenomenon.  Commission salesmen don’t make money unless you trade – a lot.  In house (sell side) analysts have powerful financial interests and heavy pressure to never issue sell ratings (though this is changing only after the carnage of the dot com fiasco).  Now that many financial professionals have turned to fee based compensation tied to assets under management (no trading commissions) the problem remains because the advisor is not compensated for managing cash.  Therefore, the client is fully invested at the top, as always.

Worse, financial planners certified in their trade routinely provide advice mathematically guaranteed to destroy even their conservative clients by misinforming them about how much they must save in order to meet their goals.  Long term investment returns were wildly overestimated.  This was not limited to the feckless individual investor.  Big pension funds, public as well as private, have fallen into financial black holes as a result.  I also cannot count the number of times financial planners (certified, no less) routinely advised their clients they could safely withdraw 10% of their assets each year after retirement.  Everyone who followed that advice is broke today.

The academicians also got into the act with their brainchild called “modern portfolio theory”.  All that was modern about it was the new language and equations replete with squiggly letters.  For example, everyone wanted to construct portfolios with low beta, high alpha assets.  In English that means buying stuff that does not move up and down very fast (low beta) and outperforms the relevant market index (high alpha).   Again, unfortunately, this new fangled alpha beta approach also guarantees buying at the top and selling at the bottom.

“Read Ben Graham and Phil Fisher, read annual reports, but don’t do equations with Greek letters in them.” (Emphasis added.)

Warren Buffett 1993

St. Warren Buffett himself pointed out years ago such notions would have you buying commercial real estate before it busted in the late 80’s and early 90’s.  He also noted that under modern portfolio theory he never could have made his legendary purchase of Consolidated Edison as it crashed following the elimination of its dividend.  Given all of this, and much more than can be recounted here, can it be any wonder that the average person is so clueless about financial matters?

This rant has been mostly about personal financial issues.  Prior posts have dealt extensively with general policy issues and economic literacy.  While the news is nearly all bad, the most important story of last week offers at least a small glimmer of hope.  The American Association of Retired People (AARP) has officially told its lobbyist to cease their reflexive hard line objection to any notion that social insecurity benefits may be cut (for future generations of retirees) as part of any reform plan.  I would have given steep odds against this development given the persistently demonstrated innumeracy and economic illiteracy of nearly everyone embroiled in this issue in addition to the traditional intransigence of AARP.

All the best to you all,

Stephen Reiss
[email protected]

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