James Surowiecki writes an excellent piece for the New Yorker on the state of financial illiteracy, concluding 1) we have it and 2) we have to get rid of it. Ultimately, he concludes that some form of basic financial education should be mandated before people can partake in purchasing financial products.
The government’s new consumer-protection agency has the authority to “review and streamline” financial literacy programs, but that’s not enough. We really need something more like a financial equivalent of drivers’ ed. There’s evidence that just improving basic calculation skills and inculcating a few key concepts could make a significant difference.
This point is particularly frightening:
Critics also argue that financial education may make people overconfident, and therefore more likely to make bad decisions. In fact, the reverse is true: the less people know, the more overconfident in their abilities they tend to be. In a German study, eighty per cent of those surveyed described themselves as confident in their answers on a questionnaire, yet only forty-two per cent got even half the questions right. This is known as the Dunning-Kruger effect: people who don’t know much tend not to recognize their ignorance, and so fail to seek better information. No wonder, then, that the least knowledgeable people in the Atlanta Fed study were also the least likely to do research before getting a mortgage.
I’ve argued for a long time that every expansion of financial markets has led to a market crash as uninformed users of new financial innovations are caught unawares when the floor falls out. This supports that theory — the democratization of markets (through margin trading, portfolio insurance, pooling funds, ETFs, online trading, etc. etc.) lets in new investors who are overconfident and underinformed. Worse, they don’t seek to correct their lack of knowledge in any way.
We’d like to believe that investing is easy and The American Way because of the obvious ties to capitalism. The truth is somewhat sobering: investing is easy; investing profitably is hard. And we don’t need to limit ourselves to speculative investing, either — financial products like credit cards, mortgages, and 401(k) can also trap people who find themselves on the wrong side of these otherwise helpful innovations.