How financially literate are individual investors?


A June 2014 study released by the Employee Benefit Research Institute concluded that many U.S. Baby Boomer and Gen Xer households are expected to run short of money in retirement (assuming 35 years in retirement): 83% of those in the lowest income quartile, 47% in the second quartile, 28% in the third, and 13% even in the highest income quartile. Another study concluded that more than half of future U.S. retirees will rely on Social Security for at least 50% of their income.

Part of the difficulty stems from the fact that many workers, both in the U.S. and worldwide, are now directly responsible for their financial well-being. Defined-benefit pensions are few and far between, as more and more employers opt instead for defined-contribution plans, where both employers and employees contribute, and employees have some discretion for management.

Financial literacy of U.S. investors

The trouble is, most individual investors are not sufficiently well-informed on financial matters, and thus often make less-than-optimal choices in managing their retirement. The 2014 DALBAR report, for instance, concluded that over the past 20 years, individual stock fund investors achieved only a 5.02% average annual return, which is considerably less than the 9.22% they could have achieved simply by investing in a S&P500 index fund. Results for other asset classes are similar.

A June 2014 study by researchers at the National Bureau of Economic Research evaluated the overall financial literacy of U.S. investors. The financial quiz posed by these researchers is available either from the WSJ site or the NBER site (the NBER version includes some additional questions asking subjects how they judged themselves). The 17 questions were grouped into five categories (compound interest, inflation, diversification, tax-deferred investments and employer contributions). Here is a sample of the questions:

  1. Consider the following scenario: Jack and Jill are twins. At the age of 20, Jack started contributing $20 a month to a savings account. After 20 years, at the age of 40, he stopped adding to his savings, but he left the money in the account. Jill didn’t start to save until she was 40. Then, she saved $20 a month until she retired 20 years later at age 60. Suppose both Jack and Jill earned 6% interest per year on their savings. When they both retired at age 60, who had more money? (a) Jack; (b) Jill; (c) They had the same amount; (d) Don’t know.
  2. Suppose that by the year 2020 your income has doubled and prices of all goods have doubled too. In 2020, how much will you be able to buy with your 2020 income? (a) More than today; (b) The same amount as today; (c) Less than today; (d) Don’t know.
  3. Suppose you are a member of a stock investment club. This year, the club has about $200,000 to invest in stocks and the members prefer not to take a lot of risk. Which of the following strategies would you recommend to your fellow members? (a) Put all of the money in one stock; (b) Put all of the money in two stocks; (c) Put all of the money in a stock indexed fund that tracks the behavior of 500 large firms in the United States; or (d) Don’t know.
  4. Which of the following statements are true? (a) In any type of IRA or 401(k) account, all of the money in your account grows tax-free; (b) If you have a traditional IRA or 401(k), you make contributions out of pre-tax income and pay income tax at your future tax rate when you withdraw the funds; (c) Both are true; (d) Don’t know.
  5. Alice wants to invest $1,000 for retirement this year. Her new employer will fully match her 401(k) contributions, up to $10,000 per year. All else being equal, which of the following options will give Alice the highest total amount at the end of the year? (a) Alice contributes $1,000 to her 401(k) plan and invests that money in mutual fund A. At the end of the year, mutual fund A has earned a 5% return; (b) Alice does not contribute to her 401(k) plan but she invests $1,000 in mutual fund B outside of her 401(k) plan. At the end of the year, mutual fund B has earned a 20% return; (c) Alice does not contribute to her 401(k) plan, but she invests $1,000 in mutual fund A outside of her 401(k) plan. At the end of the year, mutual fund A has earned a 5% return; (d) Don’t know.

The answers to the above sample questions are given below. The average score by all participants was 67%, or about 11 out of 17 correct responses. Among the different categories of questions, the questions on tax-favored assets and employer matching proved most problematic with average scores 54% and 61%, respectively. The two single most often missed questions were one about avoiding double taxation, and the question, listed as #5 above, about taking advantage of employer matching contributions.

From one perspective, these results are somewhat encouraging — after all, in many high school or college courses, an average 67% test score would qualify one for a “B-” or “C+”. But given the relatively basic nature of the questions, and the overall importance of thoroughly understanding these concepts, one has to ask if this is good enough.

What’s more, the quiz does not address some other important aspects of individual financial management, such as the oft-noted propensity of risk-averse investors to dump their portfolios at the onset of bad news, then miss much of a subsequent market rise. As MarketWatch commentator Paul Merriman observes, “Investors’ emotion-based trading is counterproductive.” Or, as the DALBAR report notes:

[A]t no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets. Recommendations by the investment community to remain invested have had little effect on what investors actually do. The result is that the alpha created by the portfolio is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news.

Retirement systems in other nations

The above quiz was, of course, targeted to the U.S. public, and is based on facts about the U.S. retirement system. But the situation is every bit as complicated in most other nations:

  • Most workers in Australia are now covered by the Superannuation program, wherein employers contribute at least 9.25% of wages, which is set to increase to 12% by 2021; some employers, such as universities, already contribute as much as 17%. The fund is administered either by the employer, the employee union, or, in some cases, by the employee. Pre-tax contributions are taxed at 15%, as are capital gains, but not if the money was contributed post-tax. Withdrawals are not taxed at retirement, provided the money is distributed an annuity.
  • The Canadian equivalent of the U.S. 401(k) is called the Registered Retirement Savings Plan (RRSP). Contributions to RRSP can be made pre-tax while working, but most withdrawals are subject to tax, in the same way as a U.S. 401(k). The Canadian equivalent of social security, known as the Canada Pension Plan (CPP), is significantly less generous than in the U.S. Also, recipients with more than CDN$67,668 total income must currently pay a 15% tax on CPP benefits.
  • Both Europe and Japan still have mandatory retirement ages, as opposed to the U.S., where workers can (and often do) continue to work long after age 65. European pension systems differ from nation to nation. Several European nations, facing severe budget pressure, have made changes to their pension programs. Poland has nationalized some private pensions.
  • Full-pension retirement ages are being increased worldwide, similar to the U.S., where the full Social Security retirement age has been raised to 67 for those born 1960 and later.

There is not much data on financial literacy in other nations, but there is little indication that this situation is significantly better worldwide than in the U.S.

Consequences of financial illiteracy and innumeracy

In an analysis of financial literacy, the U.S. Securities and Exchange Commission recently concluded:

[I]nvestors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud. … Certain subgroups, including women, African-Americans, Hispanics, the oldest segment of the elderly population, and those who are poorly educated, have an even greater lack of investment knowledge than the average general population.

What’s more, one could argue that the increasing complexity of today’s financial world requires much more of investors than in past years, whether they be professional investors working for large firms or individual investors managing their 401(k) or Superannuation account. As a single example, statistical overfitting of stock market data is rampant in the financial field, and thus investors can be led astray into investments that may look good on paper, based on impressive backtest results, but fall flat in practice.

As a colleague of ours with a Ph.D. and 35 years’ experience in the financial field confided to us recently, “I barely feel qualified to manage my own investments.”

While improved mathematical and scientific literacy is the long-term solution, both individuals and governmental agencies need to consider ways to improve financial literacy now. It seems certainly appropriate to require all employers that operate retirement systems to have mandatory training sessions where, at the least, employees are brought to the level of financial literacy required to answer the NBER questions (or their equivalents in other nations) correctly.

One key problem, which is evident just by looking at the problems above, is that some basic level of mathematical literacy is assumed — indeed, financial literacy is inextricably linked to mathematical literacy. The latest results of the U.S. National Assessment of Educational Progress (NAEP) test are not encouraging in this regard. The 12th grade overall score of 153 in mathematics was identical to the 2009 score, and only slightly higher than the 2005 score, in spite of years of effort and billions of dollars spent to improve K-12 education. Perhaps financial questions such as those on the NBER test could be worked into the K-12 mathematical curriculum.

ANSWERS: 1(a), 2(b), 3(c), 4(b), 5(a).

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