Financial literacy increases your wealth, Simplicity is Good…and my Dad

By, Bob Peters || January 19, 2023

What I hope you take away from this blog post

1. Professor Annamaria Lusardi has generated some great research on the impact of Financial Literacy or the lack thereof.
   
2. A great definition of financial literacy.
3. Research that supports that Net Worth is 30%-40% higher for individuals who have achieved a degree of financial literacy.
4. Financial literacy helps you avoid bad financial decisions while increasing your knowledge and confidence to make better financial decisions.
5. Financial literacy improves the probability you will make good financial choices early in life which will provide you more choices later in life.  More choices increases happiness.
6. I choose Simplicity over Complexity.

Professor Annamaria Lusardi…

Professor Lusardi is the Founder and Academic Director of the Global Financial Literacy Excellence Center and Professor of Economics and Accountancy at George Washington University.  For the past 20+ years she has been a leading researcher in the Field of Financial Literacy subsequent to earning her doctorate from Princeton.  She has advised the US Treasury and the Italian and Finnish governments on matters of public policy priorities to improve financial literacy.

Professor Lusardi’s definition of Financial Literacy

“Financial literacy is knowledge and understanding of financial concepts and risk, and the skills, motivation and confidence to apply such knowledge and understanding in order to make effective decisions across a range of financial concepts to improve financial well-being of individuals and society, and to enable participation in economic life.”

Implications of Financial Literacy

Some of the key concepts covered under financial literacy include risk, inflation, interest, compounding.  Lusardi determined that most citizens lack a basic concept of understanding “risk” and how insurance is used to mitigate certain risks.  She points out that awareness of an individuals’ credit score and the knowledge of maintaining a good credit score can result in material cost savings over an adults’ lifetime.

There are a few other takeaways from Professor Lusardi’s work:

-Financially literate people are more likely to participate in owning public equities (i.e. stocks) than those with less financial literacy.  We know that based on returns of equities going back to 1926 that stocks have a significantly higher long run return than other assets, including cash.  After the impact of inflation, cash provides a negative real return.  This increased participation in the ownership of equities contributes meaningfully towards the increased gap in Net Worth.

-More financially literate people paid lower fees for financial products thereby increasing their long run expected returns.

-Prior research conducted by van Gaudecker (2015) determined that the least financially literate were less likely to diversify investments (which we know leads to lower expected returns).

-Less financially literate people are more susceptible to financial scams and towards making more poor financial decisions (i.e. taking on high cost debt, too much debt).

-The least financially literate people are more likely to sell stocks when there has been a significant market correction (sell low), thereby locking in losses and reducing lifetime wealth.

A couple of Peer Reviewed Research Papers on the topic of Financial Literacy

‘The Economic Importance of Financial Literacy: Theory and Evidence’ — https://gflec.org/wp-content/uploads/2014/12/economic-importance-financial-literacy-theory-evidence.pdf

‘Optimal Financial Knowledge and Wealth Inequality’ — https://www.journals.uchicago.edu/doi/10.1086/690950

Just-in-time Financial Literacy

In an earlier blog post, Mental Immunity and Joy are Good for Achieving Financial Security, I shared the name of several leading academics in the field of Behavioral Economics/Behavioral Finance.  Not mentioned in that blog post is Richard Thaler, who is widely credited as one of the founders of this field of study of Behavioral Economics.  Professor Thaler earned the 2017 Nobel Prize in Economic Sciences which you can learn more about by visiting the Nobel Prize website.

The reason I wanted to mention Richard Thaler is because in a recent interview he made the point that what people really need is 1) just-in-time financial literacy, and 2) keeping things simple.  Thaler acknowledged that learning aspects of financial literacy such as interest, inflation, compound interest, risk management, debt, etc. are important however, most people who learn these concepts in High School or College will not remember these concepts when, it may be years later that, they need to pull these tools out of the toolbox.

So here we have it.  Professor Lusardi’s research proves out that wealth is significantly enhanced by those that have a reasonable knowledge of Financial Literacy at the same time that Professor Thaler suggests that folks may forget this learned knowledge if years pass before they need a particular tool in the toolbox.  Ergo, the purpose of this blog.

Don’t let the Perfect be the enemy of the Good

The phrase, Don’t let the Perfect be the enemy of the Good, is commonly used in the context of negotiations.  When compromise is necessary to reach a mutually agreeable solution it requires all participants to find common ground. Common ground is frequently achieved by accepting less than what each party had hoped to achieve at the beginning of their negotiation.  Clearly, there are areas where compromise is not acceptable but almost all successful negotiated agreements are the result of each party allowing for compromise.

As Richard Thaler points out, most normal people who are not finance wonks, need financial literacy and simplicity in order to activate sound decision making and good behavior.  Complexity may theoretically offer a “better” outcome but, as Thaler infers, complexity can be the enemy of executing good decision making.  Don’t let the Perfect (Complexity) be the enemy of the Good (Simplicity).

I do acknowledge that there are plenty of decisions where complexity cannot be avoided.  The point is not to avoid complexity at all costs but to minimize complexity whenever possible.  If a decision includes complexity in areas where you feel unable to fully comprehend the consequences then seek out others, who you trust and respect, with relevant experience.

Simplicity over Complexity

Here are a few examples where I believe the Good of Simplicity may serve you much better than the Perfect of Complexity:

Spending

To live a reasonably comfortable adult life you need to be able to pay for your Basic Needs, Invest Wisely and have funds left over to satisfy your Wants.  If you can’t reduce your expenses (Spending) to satisfy these three priorities (in that particular order) you will want to increase your income.  If your current employment does not offer sufficient income to accomplish this you will need to seek new employment and any level of education required to obtain that desired level of income.

I don’t mean to make this sound easy.  Getting additional education while supporting yourself on a low income will take a commitment of time, energy and resources but there is no other reasonable way that I can think of to achieve this outcome.

An Emergency Fund

An emergency fund. Notwithstanding the best Budgeting discipline, s**t happens to everyone.  It’s just life and while you can make decisions that decrease the probability of hitting life’s many road bumps you won’t be able to avoid all of them.  Obtaining and maintaining an excellent credit score can easily save you over $100,000 in your lifetime.  Lower fees and interest rates on a mortgage, car loan, credit cards.  Access to credit vs. an inability to obtain a mortgage which would preclude you from buying a home.  The negative impact of poor credit when it comes time to execute an apartment lease.  Many employers perform credit checks on potential new hires since poor credit is an indication of stress that may negatively impact employee reliability.

Bottom line…you need an emergency fund so you can cover unexpected but ever-present road bumps and maintain a good credit score.  When you use it, you need to replenish it.

Investing

Reduce the number of decisions.  Make it simple.  There are short, intermediate and long-term investing buckets that you can match with your short, intermediate and long term goals.  When you are young (20’s and 30’s) you have time on your side.  While there are never any guarantees in life, the historical returns of a highly diversified, low-cost exchange traded equity fund that you invest in regularly over many years is likely to yield you a much better outcome than deciding when and what to buy or sell.  By regularly buying (and not selling) you reduce the number of decisions and avoid unnecessary complexity.

As you get into your late 40’s and 50’s you can put more thought into asset allocation but when you are younger, low cost, highly diversified equity ETF’s are, in my opinion, where you should have most of your long term investment bucket.

Taxable, Tax Deferred and Tax Exempt

Investment Tax Channels (let’s keep it simple: Taxable, Tax Deferred and Tax Exempt).  We have talked about investment options and short, intermediate and long-term investment buckets.  Just like we created three investment buckets that define “time” we can now introduce three different investment channels that define “tax”.  Your short (3-36 months) and intermediate (36-60 months) investment buckets should generally be held in a taxable account.  You will be able to convert these investments to cash with no penalty.  To the extent that these investments pay interest, distribute dividends or generate gains, you will incur an annual tax liability that you will owe when you do your tax return.  Conversely, your long-term investments should be ideally in tax exempt and secondarily tax deferred channels). 

Let’s leave it there for now but I’ll do another post to go into this in more detail.  I do not provide tax advice but you should be aware of how taxes can affect your financial security.

We have come so far since the days of hand charting and squawk boxes

My dad became a stock broker in 1966.  Although historical data had been compiled on public security prices by the University of Chicago’s Center for Research in Securities Prices (CRSP) since 1960 the science of Finance was nascent in 1966.  It took CRSP four years until 1964 to manually compile between two and three million pieces of information on public companies going back to January 30, 1926.  This data had to be painstakenly scrubbed for accuracy.  Up until 1964, there were no complete databases of measurable business metrics found in business financial statements.  We have come so far since the days of hand charting and squawk boxes.

Here are a couple of memories that made me smile

I remember visiting my dad’s office and helping him do his charting.  There were no computers, internet, cell phones.  Other than the newspaper and paper subscriptions to Standard and Poors, ValueLine and a few other services there was a Quotron machine.  The screen had green text on a black background with no graphics.  You typed in the ticker symbol and the price of the stock popped up.  There was no historical price information…just the price and maybe the last trade and number of shares.  The price reported were generally on a 15 minute delay.  My dad “followed” companies for his clients and would use pencil and graph paper to log in the closing price of each company by hand.  In this way, he would build a historical price chart of each security.  When I would visit his office, I remember typing in the ticker and reading him the price while he took pencil to chart paper.

Around 1973, my Dad began to work with another national brokerage firm that had a Squawk Box (think intercom or walkie talkie) linking all offices with the trading floor on various exchanges.  The flow of information was much slower and less efficient than it is today.  Remember back then, no computers, no internet, no cell phone.  They used the Squawk Box to place orders on the Chicago Mercantile Exchange for bond/commodities where the broker would call in the customer order and the other end of the Squawk Box would be on the floor of the Exchange.  The verbal order would be placed and relayed to the trader covering that specific commodity and the trader would execute the trade in the trading pit using universally understood hand signals to another trader.  (In May 2021, most of the trading pits closed due to Covid.  While a few have reopened, most trading has migrated from the “pits” to online trading.  If you have a couple of minutes to see what it was like to execute trading before they moved online, enjoy this Chicago Board of Trade:  “For Cryin’ Out Loud” video.)

Exchange Traded Funds did not show up until 1989.  Today there are more than 3,000 available in the United States.  The cost of mutual funds and ETF’s has been reduced dramatically over 30+ years.

Fast Forward

Fast forward to 2023.  CRSP has continued to maintain this database which has been used by academics in Finance, Economics, Behavioral Finance as well as businesses to develop and maintain indices used to measure relative performance.  The internet has made almost all information accessible to everyone in the world virtually instantaneously. The price of all trades is available real time with no delay.  The markets are much more efficient.  Remember, this near 60-year evolution of finance and investing science can be simplified as such:

-save and invest early in your life and keep investing

-use available very low cost, highly diversified ETFs

-understand investment buckets and investment tax channels

-recognize the importance of behavior to achieving financial security

-Simple is better…don’t try to beat the market