Wednesday, June 8, 2011

Majority of Americans Practice Poor Financial Planning

The National Bureau of Economic Research has released a report critical of American investing practices. The study indicates that most Americans are financially illiterate, and do not understand fundamental concepts regarding their borrowing practices or the dynamics of finance. People often borrow or enter into mortgages without understanding their interest rates or terms, and increasingly use risky high-interest forms of financing like payday loans and tax refund advances. This along with a seeming addiction to credit and aversion to saving has experts warning of future economic shocks stemming from large-scale personal finance mismanagement. For more on this continue reading the following article from Tim Iacono.

It’s impossible to predict what the personal finances of hundreds of millions of Americans will be like in 10, 20, or 50 years, but one thing seems certain – they’ll look back at the late-20th and early-21st century and marvel at what happened. From a nation of diligent savers where a reasonable return could be earned on risk-free investments and everyone worked toward paying off their mortgage, we’ve gradually turned into a nation of credit junkies who fall into two investment camps – increasingly destitute, risk-averse savers and speculators reaching for a higher return, many of whom will end up destitute as well.

Confirmation that we might be getting a little closer to the end of this trend and about to begin whatever phase comes next arrived in two reports this week. First, from the National Bureau of Economic Research comes a new study that indicates we Americans don’t seem to do much right these days in managing our money.

The findings reported in this work paint a troubling picture of the state of financial capability in the United States. The majority of Americans do not plan for predictable events such as retirement or children’s college education. Most importantly, people do not make provisions for unexpected events and emergencies, leaving themselves and the economy exposed to shocks. To understand financial capability, it is important to look not only at assets but also at debt and debt management, as an increasingly large portion of the population carry debt. In managing debt, Americans engage in behaviors that can generate large expenses, such as sizable interest payments and fees. Moreover, more than one in five Americans has used alternative (and often costly) borrowing methods (payday loans, advances on tax refunds, pawn shops, etc.) in the past five years. The most worrisome finding is that many people do not seem well informed and knowledgeable about their terms of borrowing; a sizeable group does not know the terms of their mortgages or the interest rates they pay on their loans. Finally, the majority of Americans lack basic numeracy and knowledge of fundamental economic principles such as the workings of inflation, risk diversification, and the relationship between asset prices and interest rates.

You can purchase the report for $5 from NBER or have a look at some additional details in this item over at the Wall Street Journal Economics blog, but, it seems clear that the too-big-to-fail banks have millions of Americans right where they want them – dumb and in debt – and even Elizabeth Warren might not be able to save them.

When it comes to investing (i.e., for those Americans who aren’t living paycheck to paycheck while struggling with debt up to their eyeballs), things aren’t much better as the double-whammy of poor instincts and being taught poorly have investors failing to achieve their potential as detailed in this report at MarketWatch.

It might be a stretch to say that Americans, in general, are failures when it comes to investing. But given the amount of time and attention spent teaching people how to be savvy about all things money, it sure seems that way.

We simply haven’t moved the needle all that much. That seemed to be the consensus of the world-renowned experts who spoke at the recent Life-Cycle Saving & Investing Conference at Boston University.

It’s not that investors don’t understand how the economy and markets work, though that is a problem. The problem is that we have — recent trends notwithstanding — a low savings rate and high personal debt. What’s more, average investors typically have poor investment results, with various studies suggesting they tend to buy high and sell low, or trade frequently and at the wrong times.

We keep trying to teach people (children, teenagers, young adults, 401(k) participants and the like) about money at all the wrong times, using all the wrong formats and methods of delivery.

Experts said the time is now to think differently about how we teach people about investing, with some advocating for increased use of financial entertainment, or what some call edutainment. Others are calling for increased use of just-in-time learning programs, and still others say this nation needs to address the heart of the matter.

At the core, one reason why Americans are illiterate when it comes to money and investing has to do with numeracy, Horan said. There’s simply a lack of it among the general population. And, “when we look at the efficacy of financial literacy programs the evidence is not all that compelling,” said Horan.

Horan said that Lauren Willis, a professor at Loyola Law School, published a paper in 2008 in which Willis noted that financial education, for some consumers, appears to increase confidence without improving ability, leading to worse decisions.

I suppose, in the case of investing, you could say that Wall Street firms have millions of Americans right where they want them – confused and reaching for yield.

The “numeracy” problem cited in both reports is something that I find hard to fully appreciate, given my math/engineering background, but it sure does seem to be a problem with no easy solution in sight given the increasingly complex financial world we live in.

This post was republished with permission from The Mess That Greenspan Made.

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