Monday, 14 June 2010

Financial Literacy Proposals - You Gotta Be Kidding!

Amongst the less-than-sensible ideas floating around these days is the notion that the general population can be sufficiently trained to successfully manage on their own all their finances, investments, pensions and the like. There's even a national task force doing the rounds of consultation to come up with a strategy.

There are two big reasons that proposals to improve financial literacy don't make sense:
  1. It's not knowledge, it's behaviour that is the key problem people have - not saving enough and taking too much debt results more from lack of judgment and self-control not from knowing the difference between simple and compound interest. The large and growing body of research on behavioural finance shows that the main impediment to financial and investing success is the irrational decisions we are all too prone to make. I do believe it is possible to train people to a certain degree - some people being more naturally capable of being trained, just like some people learn to play golf faster than others, even with lessons. However, I seriously doubt that the task force will be going down that path (unless somehow the "skill" they define as being part of financial literacy means the ability to manage their own reactions, impulses, fear, greed, over-confidence, framing errors and all the other quirks, foibles and thinking errors identified in behavioural finance).
  2. It is rocket science - whenever people give out simplistic financial advice it reminds me of simple instructions for playing the clarinet "just blow in the top and run your fingers up and down the holes". Modern finance is not simple. Part of the cause of the credit crunch and financial crisis is apparently that the executives of the banks did not themselves understand the models and products concocted by the math and physics PhDs. Look at the random page below from the book The Calculus of Retirement Income by Moshe Milevsky one of the few dozen people on this planet who properly understand how pensions work. I don't know about you but I have an MBA in Finance, I have spent the last three and half years reading and blogging about investments and personal finance and I estimate it would take me about another two years of hard work to relearn math sufficiently to really understand what he has written.

Noted author William Bernstein writes in his latest book The Investor's Manifesto: "I have come to the sad conclusion that only a tiny minority will ever succeed in managing their money even tolerably well." By managing their money, he means the ground-up type of DIY investing that is assumed when the leaders of our society foist defined contribution retirement plans and RRSPs upon us and pretend that we will be fine with a little "financial literacy" i.e. technical knowledge of finance. Bernstein does propose some relatively simple methods, imperfect but much better than what happens now, but I doubt they could be adopted as public policy education goals due to their bias in favour of some specific industry products like index funds and against others like actively managed mutual funds that are perfectly legal though harmful to the investor.

So what could and should be done? First, I believe the government should undertake public behaviour modification in favour of saving more and borrowing less. A societal attitude change is necessary - like anti-smoking and anti-drink driving. Second, proper retirement income reform that considers first and foremost the income needs of retirees along with the risks they face in retirement needs to happen. I'll post more about that tomorrow.


Canadian Couch Potato said...

A thoughtful post, and I agree with your first point entirely. However, I think your second point is misleading. The Milevsky book is a textbook, not intended for the general public. You don't need anywhere near that level of sophistication to manage your own finances. Building a low-cost diversified portfolio is not "rocket science." You need to read a few books and spend some time on it, and you need high school math skills, I suppose, but that's it. said...

I agree with CCP. You are selling too many people short. With a modicum of wisdom most investors can do very well with financial planiing and investing.Befor behavorial change must come knowlege and understanding. The task force (and it's recommendations) might help.

CanadianInvestor said...

Potato/Straight talker, I guess what you say is true ... if you happen to read the right books with sensible advice, you can probably make out reasonably well. However, it still leaves the issue of how can people learn to tell apart good advice from bad advice? You must get really expert to do so. Take one controversial(?) example - do you invest in market-cap index funds or are fundamental/equal weight index funds better? Want to form your own opinion, then better start reading fairly sophisticated stuff like the Andre Perold paper, the Arnott-Hsu papers and the EDHEC institute assessment.

In the end, I do believe financial literacy can be useful when given from an early age in schools, where other literacies are taught. It will also be especially useful when financial planners are required to have much greater financial literacy too (along with a fiduciary duty).

chandra said...

You were absolutely true in saying "It's not knowledge, it's behavior" attitude is every thing

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