Isn’t it paradoxical that at a time when all of humanity has access to the entirety of human knowledge, financial literacy is actually declining? Unfortunately, this coincides with a crisis in which financial literacy would be essential for us.
But what exactly is financial literacy?
Financial literacy is knowing how to manage your finances appropriately to achieve your own financial goals. It covers the areas of earning, spending, saving and investing, protecting and borrowing.
In the US, the FINRA tries to measure financial literacy using a test consisting of the following 5 questions.
- Suppose you have $100 in a savings account earning 2% interest a year. After five years, how much would you have?
a) More than $102
b) Less than $102
c) Exactly $102
- Imagine that the interest rate on your savings account is 1% a year and inflation is 2% a year. After one year, would the money in the account buy more than it does today, the same or less than today?
- If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
c) Stay the same
- True or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.
- True or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.
Answers: 1a, 2c, 3b, 4a, 5b
How many of these did you get right? For reference, the average US citizen answers 3 of the questions right and only 34 % answer 4 out of 5 correctly. If you got 5 right, you’re more financially literate than a majority of the US population.
A separate study conducted by the OECD explored how individuals in different countries were managing their finance on a day to day basis. They interviewed people from 26 countries worldwide and gained some surprising insights:
- While simple interest on loans is well understood by 84.4% of participants, only 26.3% could correctly calculate compound interest.
- 80% of respondents could define the meaning of inflation but only 59.9% were able to apply this knowledge in practice to calculate the value of money over time
- 77% know about the relationship between risk and return, yet only 58.9% manage to answer correctly how diversification impacts risk.
- Overall, only 16.7% of the respondents were confident in their own financial knowledge.
- 28% of participants only have enough savings to cover for one week.
These findings are particularly troubling when we consider the current state of the world economy. The IMF projected a drop of global GDP by 4.4% in 2020 and increasing debt levels might stall recovery going forward.
Why does financial literacy matter?
“Financial literacy is just as important in life as the other basics.”
— John W. Rogers Jr.
Even before a virus swept across the world, many of us were living paycheck to paycheck and student debt was ever-increasing.
Increasing responsibility and choices
On top of that, we’re more and more responsible for our own financial choices. Even when picking something as seemingly simple as a bank account, we’re confronted with a huge variety of options and advertisements luring us in by offering us £200 for our first current account. With financial products like credit cards, the options are even more varied. Yet, at the end of the day what really matters is understanding compound interest.
In addition to having to choose between an unrivalled number of financial products, our options for saving and investing have also increased dramatically. Nowadays, anyone can be an investor by simply downloading an app like the now-notorious Robinhood or Trading 212 and start investing.
The democratization of investment has also exposed more individuals to inherent volatility in the market. During the latest Gamestop Frenzy, a few traders undoubtedly managed to go out of it with high returns, but many other traders are either still holding the line or got so terribly burned that they might never invest again.
The rise of “Buy Now, Pay Later”
Another financial service that has done tremendously well during the last year is “Buy now — pay later”, the most famous in Europe being Klarna. The “buy now pay later” market is expected to grow by 400% — a rise that is majorly driven by a boom of e-commerce spending. This trend has been welcomed by retailers, who are happy to share a percentage of their revenues with these service providers because they know that consumers will frequently spend more than they would if they had to pay instantaneously.
While some of us have happily spend lockdown shopping their boredom away, others haven’t been so lucky. A significant portion of people have not only lost their jobs but face difficulties making ends meet. In countries like the UK, Germany and France, governments have pledged funds to support struggling businesses and individuals to stay afloat. In contrast, in the US citizens have had to make due with a single stimulus check which barely covered expenses for a month.
Loss of income
When faced with a sudden loss of income, many people resort to credit cards for daily purchase. Using a credit card in itself is not a bad thing. However, if credit card debt is not paid off within a specified timeframe it can quickly spiral out of control. That which works beautifully in our favour when it comes to investing can push us into debt when working against us: compound interest. A concept only understood by 26.3% according to the OECD. And when credit limits are exhausted, many are forced to take out loans with often unfavourable conditions — making matters worse.
Lack of financial education
Despite an abundance of financial products, financial pressure and negative impacts from the pandemic adding up, there is still little to no supports from governments to educate their citizens about finance. A cynic might see a good reason for that…
One can graduate college without knowing how to budget or how to manage risk when investing. Many even without an idea on how to calculate compound interest on a credit card. And while that might seem like problems of individuals, they add up to society-wide issues. Just think about the financial crisis of 2008 that ultimately came down to consumers taking on debt they could never pay-off and banks serving them regardless.
Another reason why financial literacy matters that is often forgotten is our psyche: Not having a good grasp of money management leads to higher stress levels and anxiety.
To sum it up…
If you don’t feel confident about your financial knowledge you’re not alone. However, this shouldn’t be a reason to ignore it. Financial literacy is more important than ever because we face:
- increasing choices over more complex products
- increasing debt levels worldwide
- exposure to uncertainty and volatility in financial markets
- lack of government support
- anxiety and fear from not having control over your finances
Ultimately, having control over your own finances gives you control over your future and increases your mental wellbeing. It might seem overwhelming at first, but it really comes down to knowing your way around earning, spending, saving & investing, borrowing and protecting. These are all areas that you can master step by step with a little effort.