A Little Financial Knowledge Is a Dangerous Thing

The Citi Smith Barney chap at my local Citibank branch is very sweet. Whenever anybody asks to open a brokerage account, he tells them that he's not a discount brokerage, and that there are lots of discount brokers like E*Trade who can provide brokerage services at a much lower cost. But I have a feeling that a discount broker might not actually save you money. Dean Baker explains, in the context of talking about cuts in capital-gains taxes:

There is one other important point worth noting about the [lower] capital gains leads to more taxes story. Presumably the greater collections are supposed to come from people selling their stock or other assets more frequently. This means more fees for the financial industry, but is this what we really want to promote. The fees from these trades are a drain on people's investments. There is a lot of research showing that active traders typically lose money.

When a stock trade costs less than a latte, the barriers to trading in and out of stocks become so low as to be all but nonexistent. And that's not necessarily a good thing at all.

Lauren Willis at the Loyola Law School in LA takes this argument one step further, and says that consumers shouldn't even bother with financial literacy:

The pursuit of financial literacy poses costs that almost certainly swamp any benefits. For some consumers, financial education appears to increase confidence without improving ability, leading to worse decisions. When consumers find themselves in dire financial straits, the regulation through education model blames them for their plight, shaming them and deflecting calls for effective market regulation. Consumers generally do not serve as their own doctors and lawyers and for reasons of efficient division of labor alone, generally should not serve as their own financial experts. The search for effective financial literacy education should be replaced by a search for policies more conducive to good consumer financial outcomes.

I do think that it's worth taking an empirical look at the outcomes of financial education: if it doesn't make people better off, then it's probably not a good idea. And I also think that any intuitions I might have about the usefulness of financial education are pretty useless, since a lot of things which are obvious to me turn out to be really difficult for most people to understand. There's a lot of ignorance out there:

Olivia Mitchell and Annamaria Lusardi found many people do not even have the most basic financial knowledge. Most people do not know the difference between debt and equity, yet are responsible for saving and investing for their retirement. We have a population of people responsible for their financial future and ill-equipped to do so.

And we're not just talking about saving and investing, either: We're also talking about home buying. In my experience, almost nobody understands the concept of opportunity cost or is capable of really internalizing the idea that renting can genuinely be cheaper than buying. Rent is always considered "wasted", while interest payments (not even principal payments) on a mortgage are considered, well, not wasted.

In general, I'd say that financial education is worthwhile only insofar as (a) it actually works, and (b) it not only gives people new information but also hammers home to them that even after their education they still know almost nothing and can't expect to beat the market or make huge amounts of money by doing things like buying a large house with a large mortgage. What I call "financial wellness" is basically the art of spending less than you earn, not being greedy, and minimizing indebtedness. Learning about the ins and outs of the stock market is probably going to be more damaging than useful, much of the time.

Comments

[HARM:]

(quote:) "Consumers generally do not serve as their own doctors and lawyers and for reasons of efficient division of labor alone, generally should not serve as their own financial experts. The search for effective financial literacy education should be replaced by a search for policies more conducive to good consumer financial outcomes." (end quote)


There is some merit to the second idea, but little to the first.

There is no reason why your average investor cannot learn enough about basic finance to create a budget, calculate mortgage payments and invest in his/her own 401k/IRA. I disagree with equating retail investing with performing surgery or practicing law. Medicine is (more or less) applied science, even though it evolves constantly. Practicing law takes years to learn and perfect, given the complexity of the legal system. OTOH, Basic finance is something that can be taught in a few days, assuming the person can perform simple arithmetic. There is also a HUGE difference between being a professional Quant or FT daytrader vs. just learning enough to *not* get screwed on a subprime mortgage.

However, I do agree that current mortgage market regulations (or to be more accurate, mortgage market *subsisdies*) are wholly inadequate to the task of protecting consumers from the worst sort of abuses that took place --virtually unchecked-- over the past several years.

2008 Apr 17 03:49 PM

[ValueHunter:]

I respectfully disagree. Anyone who can grasp the principle of keeping expenses down, investing for the long term, dollar cost averaging and even the basics of value investing can and should be able to do better than all those mutual funds most people are putting in their retirement accounts. The reason most people lose money in stocks, is that they are not investors, they are traders and as such, they put themselves on an emotional roller coaster on a daily basis. Every day I see some incredibly stupid comment or question which goes like this, "My G.E. is down 16% since I bought it last month, should I sell?"

As for R.E., my daughter is in her early 20s and owns her own house. She would never dream of getting an A.R.M. She would never dream of having mortgage payments that are such a large part of her income that she could get in trouble if some adverse contingency came up. She would never have bought her house without doing due diligence about economic conditions in her area and median home price histories in the surrounding area.

Her daddy made sure that she knows how to do basic math and to always remember that you can't cheat an honest man (or woman).

2008 Apr 17 04:26 PM

[Itsjustal:]

Right on, ValueHunter!!! :)

2008 Apr 17 06:39 PM

[Hoot85:]

A bit of financial education can go a long way. I am in my early 20's, and have had to learn everything on my own. What I have learned in say, the past couple months, has greatly improved my situation. I used to live paycheck to paycheck. Now, making the same money I did a year or two ago, I have managed to rack up over 15,000 dollars with a brokerage account that started at 1,000 bucks with an online discount broker. Some of that money has been in the form of dividend checks, interest payments, as well as regular, bi-monthly deposits. Had I watched my parents to learn how to handle finances, I would have two seperate views: on my father's side, I would have learned how to become heavily indebted, and continuing to accrue debt to dig myself out of debt. On my mother's side, I would have learned how to stash cold hard cash in a coffee can, then bury it in the backyard. Neither of those would have left me where I am now. As long as the person learning never gets to the point of thinking they can "time the market", the more they learn the better.

2008 Apr 17 07:36 PM

[globalmacro:]

This makes a ton of sense. Thanks.

2008 Apr 17 09:27 PM

[No Moss:]

Makes a lot of sense. John Bogle redux. Bogle's theory--well, it's a particularly good theory if you're the head of a mutual fund company--is that you invest in low-cost index funds and let them ride. Not a bad idea, and one that will make you money over time.

It takes time and enormous effort to get better at investing, and even then you have to have the discipline and the common sense to avoid egregious mistakes.

Most people who pick stocks are wrong most of the time. Yep, even Cramer. The trick is losing small amounts on your mistakes and trying to make big amounts on your winners.

I'm gonna hit the new Microsofty one of these days. Honest, I am. Honest.......

2008 Apr 17 11:49 PM

[bcncv:]

I agree with your idea that uninformed active investors will underperform index investors or professional traders. However, the idea that LESS financial knowledge will solve the problem is ludicrous.

Which person is better off?
1. The "average" day trader who underperforms the market.
2. The "average" American with no savings and paying 15% on a maxed out credit card.

In addition, how will the average American know if they can trust a financial adviser if they don't have a rudimentary knowledge of finances? The sad truth is there are any number of advisers that prey on people with no investing background.

2008 Apr 18 12:55 AM

[ericinNE:]

I can't decide if this elitist crap, or a sincere opinion that just happens to ignore the consequences of a society with a majority of the population having no basic economics/financial literacy.
My mother-in-law fits the profile. She hemmoraged money out of her IRA's and cash investment accounts from Nov.-early Jan. until I finally got a chance to review what her "financial advisor" at Wells Fargo had put her into, (and then turned his back on, while over $25000 disappeared in that time.) She had no clue what was happening, what the driving forces were, how those forces were directly affecting her, etc.
Almost all professional financial advisors somehow find a way to rationalize putting their unknowledgable clients into load funds, high fee/long term contract annuities, and other fee paying (to the advisor) investments. Gee, I wonder if there's a self serving agenda/conflict of interest issue, here?
Can a little knowledge be dangerous in the hands of the arrogant? Sure. But to suggest that individuals are not absolutely the best person to oversee and direct their own investments, is rediculous. And for competent oversight, financial literacy is a must. Along with an understanding of basic economics. My mother-in-law has become very motivated to gain that literacy, now that the consequences of NOT having it have been driven home in the harshest of ways.
I would be willing to bet that more wealth was lost from retirement accounts this last go around, than in a long time. Most all of it could have been avoided if they had been more financially literate, economicly aware, and in control of their own accounts. Regulation will never be a superior model for success. As an integrated aspect of self reliance, yes. But as a replacement for self reliance? I think not.

2008 Apr 18 01:20 AM

[I'm a Sucker:]

Only idiots will turn their money over to idiots. Never take financial advice from someone who has a job.

2008 Apr 18 02:01 AM

[ArtS:]

Sure, why get an education, when there are plenty of professionals at Citibank and Bear Stearns you can trust with your money?

2008 Apr 18 07:48 AM

[Nick Gogerty:]

The line between entertainment and investment can become very thin, a dangerous thing. Average individuals confuse activity (trading) with value creation.

2008 Apr 18 08:36 AM

[jackooo:]

I would rather lose the money myself than pay a mutual fund a commission to lose it.
The reason Franklin Templeton has that name is because one bought the other out because it was hemmorageing money and they did not want to lose the clients they had.
That said, most people are ignorant of the basics of investing. They are ignorant of balancing their check book. They figure if they have checks then they must have money in the account!
Personally I want control of my funds. A mutual fund is not the way to do it.
My rule #1 is: If it doesn't pay a dividend, (at least 3%) I don't think of buying it.

2008 Apr 18 01:51 PM

[WAKEUP:]

Rubbish. Sheer elitist egotism, perhaps tinged with a bit of fear that small investors will grasp the fact that, with intelligent study, there are opportunities to make profit without PAYING "experts," like the author, Felix Salmon. Smacks of the worst kind of European snobbishness. Rubbish.

2008 Apr 18 02:42 PM

[Robert Trudeau:]

Felix, great sketch. Just like the Wall Street Journal, huh. Did you reach a conclusion or did I miss it? It aint the education/information that's bad or good, its what you do with it. Idiots will be idiots whether they are informed or not. You elitist. And by the way, most people should pay qualified experts to assist them in making financial decisions. But good luck in finding one, and remember when you do, he is gonna want to get paid. Nothing wrong with that.

2008 Apr 19 08:46 PM