Miscalculating your way to financial mistakes.
A version of this article originally appeared on our US site, Fool.com.
In a 2009 NBC/Wall Street Journal poll, 8 in 10 Americans said they were concerned about the federal deficit and growing national debt.
But a separate poll that same year asked, "How many millions are in a trillion?" and 79% of Americans either answered wrong or didn't know.
Think about that. Eight in 10 Americans are worried about the national debt, but the same number can't accurately put the numbers into context. How do you know if $15 trillion of debt is dangerous if you don't know what a trillion is?
Deficits are something to be concerned about. But a bigger threat to your personal finances exists: innumeracy.
In a recent paper titled "Numeracy, Financial Literacy, and Financial Decision-Making," Dartmouth economist Annamaria Lusardi came to a shocking conclusion: Most young baby boomers about to enter retirement struggle with basic, real-life financial arithmetic. And those who need the most financial knowledge tend to be the most innumerate.
Here's an example:
"Let's say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?"
Take your time. Feel free to use a calculator. What's your answer?
When asked, 82.2% of those age 51 to 56 couldn't produce the right answer ($242). Of those who answered wrong, about half erred by ignoring that interest accrues on both principal and interest -- compound interest.
That was one example of many. Given three basic questions on interest, division, and percentages, only a small fraction of those about to enter retirement could answer all correctly.
"These are pretty dismal findings, considering the complexities of the calculations involved in many financial decisions," Lusardi writes.
Dismal and scary. In 1979, 38% of private-sector workers were covered by an employer-provided pension plan that required minimal planning on their part. By 2008, just 15% were. At the same time, defined-contribution plans that require workers to plan and manage their own funds ballooned, covering 43% of workers in 2008 from 17% in 1979, according to the Employee Benefit Research Institute. Unlike the past half-century, Americans' "retirement security will depend ever more on their own decisions" going forward, Lusardi writes. And yet look at where we are.
But what's fascinating about all of this is that the standard response -- that we need more financial education and more emphasis on financial literacy -- may not be the complete answer. Lauren Willis at Loyola Law School has shown (link opens PDF) that financial-literacy programs can actually be harmful to people's financial wellbeing.
How? For some, it increases confidence without improving ability. You can imagine someone taking a one-day class on derivatives trading and suddenly thinking they're George Soros, only to watch their portfolio disintegrate through hyperactive and ill-informed trades. That's an extreme example, but it captures how people actually behave. Put simply, there is "no reliable empirical evidence that financial-literacy programs are effective," Willis writes.
The key to getting people to make smarter choices with their money, then, may not be financial literacy or numeracy in itself. It's combing literacy with a proper understanding of the softer sides of financial knowledge -- things like behavioural finance, psychology, and emotional intelligence. Widespread innumeracy is a sign that financial education is lacking. But it's the emotions of finance that really influences how people manage their money.
Take a well-known example. In 1998, the hedge fund Long Term Capital Management, staffed thick with Ph.D.s and two Nobel laureates, exploded under an almost incomprehensible amount of leverage. Behind the failure was management's utter lack of emotional control. "The young geniuses from academe felt they could do no wrong," wrote Roger Lowenstein in the book When Genius Failed.
Warren Buffett later said this about the firm's 16-person management team:
"They probably have as high an average IQ as any sixteen people working together in one business in the country ... just an incredible amount of intellect in that group. Now you combine that with the fact that those sixteen had extensive experience in the field they were operating in ... in aggregate, the sixteen probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worths in the business. ... And essentially they went broke. That to me is absolutely fascinating."
The managers of LTCM had higher financial literacy and were more numerate than almost anyone on the planet. And they literally went bankrupt.
On the contrary, three years ago I interviewed hedge fund manager Mohnish Pabrai, whose track record puts him among the top money managers of the past decade. Pabrai doesn't use analyst teams. He doesn't use complex spreadsheets. There are no Bloomberg terminals in his office. I'd be surprised if he owns a calculator. When I asked him what his edge was, he replied, "Control over my emotions." That's it? I asked. "It's huge. You'd be surprised."
Pabrai understands finance, of course. He's quite numerate. But it's the emotional intelligence he applies to that knowledge that allows him to make smart financial decisions while so many others make mistake after mistake. That speaks volumes about what a useful financial education should include.
So what's the solution? We do need more financial education that teaches basic numeracy, but that education should first and foremost teach the emotional constraints of finance. After all, it doesn't help to know what APR is unless also taught that bankers selling loans rarely have your best interest at heart.
Knowing how to read a balance sheet doesn't help unless you also appreciate the biases that cause investors to buy high and sell low. And understanding compound interest won't help without conquering the social pressures that prevent people from saving money in the first place. We must focus on fixing America's innumeracy. But it's like Aristotle said: Intelligence without wisdom is worthless.
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