Financial Literacy, Part 1

Given the state of the global economy, the need for financial literacy should be self evident. Life is complicated. And in that complicated life, we all must make sometimes difficult choices, based on the best information we can gather and our interpretation of it.

But, according to a column by Robert Shiller in yesterday’s New York Times, that knowledge is sorely lacking. In How About a Stimulus for Financial Advice? Shiller extols the benefits that would be derived if the government subsidized the financial advice and education that the majority of people desperately require.

Shiller discusses several studies which prove that lower-income consumers are no match for the sophistication of financial service providers. Some of the revelations are quite shocking. Take his example of payday loans. You probably get spamvertisements for them in your email box all the time. But did you realize that  “payday loans — advanced to people who run out of cash before their next paycheck — exploit people’s overoptimism and typically succeed in charging annual rates of interest that may amount to more than 7,000 percent.” You read that right, 7,000%.

Shiller focuses on the need for financial education specifically for those less fortunate, because, in his reasoning, wealthy folks already have access to good advice. I, however, would say that we all need more education, sophistication and good advice; case in point, the billions of dollars lost by wealthy “educated” investors in the Madoff scam.

To confirm that you too need objective advice, ask yourself (or check your records) how much money is your financial advisor making from you? I can pretty much guarantee that your financial service provider knows the answer to that question, probably to the penny. See my previous posts on why it is not in his or her best interest for you to know that answer.

Here are some relevant quotes from the Shiller article.

In evaluating the causes of the financial crisis, don’t forget the countless fundamental mistakes made by millions of people who were caught up in the excitement of the real estate bubble, taking on debt they could ill afford.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. For example, the Treasury announced the creation of an Office of Financial Education in 2002, and President Bush started an Advisory Council on Financial Literacy a year ago. These initiatives are involved in outreach to schools with suggested curriculums, and online financial tips. But a much more ambitious effort is needed.

The government programs that are already under way are akin to distributing computer manuals. But when something goes wrong with a computer, most people need to talk to a real person who can zero in on the problem. They need an expert to guide them through the repair process, in a way that conveys patience and confidence that the problem can be solved. The same is certainly true for issues of personal finance.

One wishes that all this financial cleverness could be focused a bit more on improving the customers’ welfare!

The theory of capitalism, going back to Adam Smith over 200 years ago, sees an alignment of interest between consumers and businesses. Only those companies that produce what consumers really need will succeed. Those that do not will be beaten in the marketplace as consumers shop elsewhere. This puts pressure on providers to innovate and to better satisfy consumer needs.

This theory assumes, however, that consumers are rational in their choices, and to a large extent they are. But in some areas, notably personal finance, it is important to recognize that a good share of Americans have difficulty figuring things out.

Most people get financial advice only from sales representatives of one sort or another: real estate agents, mortgage brokers, sellers of financial products. Some of these providers could use their sophistication to exploit people’s tendency to behave irrationally, and to manipulate the judgment errors that consumers typically make. And competitive pressures tend to make providers promote products that exploit those errors to the hilt, unless, of course, we offer consumers real financial advice.

Conclusion

Shiller acknowledges that there is no silver bullet to the issue of financial education and risk taking. However, “it’s still likely that advisers who built long-term relationships with their clients, and who pledged to look after their welfare, would have been a helpful influence, suggesting caution to those who were getting over their heads in debt, and warning that adjustable-rate mortgages could be reset upward, just as the fine print said. For these reasons, financial advisers probably would have reduced the severity of the housing bubble.

Professional financial advice is now generally accessible only by the relatively wealthy. Changing this would be an important corrective step. Giving the general public access to trained advisers would be a boon for the nation in this time of doubt and distrust.”

Shiller raises some very good points. He envisions a government subsidy to help pay for one-on-one financial counseling. I personally believe that part of the needed education and counseling could be delivered with a combination of classes and individual consulting, in order to keep costs down. But I am with him entirely when he says that advisers should have long-term relationships with their clients and that advisers should pledge to look after their clients’ welfare.

A previous post discusses the desirability and practicality of working with someone who is a fiduciary, as opposed to a registered representative.