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Week of March 14, 2019

Can you assess financial literacy with five questions? 

A variety of studies and statistics correctly point to the the dire state of financial literacy in the US.  One of the more commonly quoted is that only 24% of Millennials have basic financial knowledge. We wanted to look deeper at the source of the survey methodology behind this statistic.

The statistic is based on Millennials’ performance on a five-question quiz created by FINRA.  FINRA is the well-respected organization that, in concert with the SEC, regulates the financial services sector.  We understand the utility behind a simple questionnaire as it can be used easily for longitudinal and cross-country comparisons.  However, its simplicity can undermine its usefulness as a tool for quantifying and qualifying the current state of financial literacy.

There are a number of challenges with the current quiz:

  • Is it just a math test?  Americans are spectacularly bad at math.  If you ask a student to figure out the value of an interest-bearing savings account after a few years, are you testing his financial literacy or his ability to do math?

  • Is it just a econ test? This is a bit subtler, but a test of economic facts may have little bearing on day-to-day activities.  

  • Is it relevant to today?  The most important challenge is whether or not the quiz speaks to what is going on today.  How are investments being made today? What does the change in home ownership rate signify? Are we ensuring that there is general understanding about the most important and relevant issues facing young people today

Did you know...

37% of Millennials own houses -- down 8% from previous generations at the same time in their life. The jury is still out whether this is a permanent gap or just a time shift in home ownership.


Breaking the questions down  

Question #1: Interest

Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much would you have, more or less or exactly $102?

While the question is meant to the get at the respondent’s understanding of compound interest, this is a math problem, and not the most straightforward one at that.  In full disclosure, we got this problem wrong because we misread that the calculation was over five years not one year.

Question #2: Inflation

Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?

This is a good question.  Understanding the dynamic between your rate of return and the cost of living is an important concept.  

Question #3: Bonds

If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?

This is an economics question and, arguably, not relevant. Less than 1% of Americans directly own bonds.

Question #4: Mortgages

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.

It’s important to understand the financial structure of mortgages; however, selecting the best mortgage is significantly more complicated.  Note that less than 10% of mortgages are 15-year, mostly due to the fact that owners cannot afford the higher monthly payment for the property they want.  Purchasers need to also consider fixed versus floating rate, down payment size, closing costs, and a variety of other factors. Given the generational trend towards renting versus owning, a different question may be more effective at testing financial literacy and real-life decision making abilities.

Question #5: Stocks and Risk

True or false: Buying a single company's stock usually provides a safer return than a stock mutual fund.

Less than 15% of Americans own an individual stock.  Individual stock ownership has been progressively declining starting first with the advent of the mutual fund, the more recent switch to ETFs, and now the rise of robo-investing.  Stock picking should be considered an advanced financial skill rather than the a foundational one.

Bonus: Doubling and the "Rule of 72" 

Suppose you owe $1,000 on a loan and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

This is another financial math fact.  Akin to knowing that the individual digits of any number divisible by nine adds up to nine.  This bonus question is about the rule of 72 -- divide 72 by the interest rate and you get the number of years until your principal doubles.  In this case, 72 ÷ 20 = 3.6. ROYGBIV anyone?


What we found interesting

Allowance from the Government

Most European countries pay families to cover the cost of raising a child.  Some programs are means tested -- like the Child Benefit in the UK -- and others are not, like Kindergeld in Germany.  A New Zealand program even gives families a Fall back-to-school grant in addition to monthly payments. Recently, two U.S. Senators introduced the American Family Act with the goal of raising 4 million children out of poverty.  

Stocks for Jocks

Baseball’s Hot Stove has resulted in two players landing contacts of over $300 million. But, massive contracts are no guarantee of being set for life.  While some athletes like Rob Gronkowski have made a brand out of frugality -- yes, that Rob Gronkowski -- reports are that up to 60% of basketball players go bankrupt and over 70% of football players have money issues.  We recently came across two other athletes that have not fallen into that trap, the NFL’s Brandon Copeland is teaching a UPenn class and ex-NBAer Chris Dudley has become financial advisor to help others.

Giving kids the vote

In 1971, the 26th Amendment to the U.S. Constitution followed the 15th and 19th Amendments in broadening who could vote.  The 26th Amendment reduced the age to vote from 21 to 18, and was rationalize by the fact that the Vietnam War draft reached down to 18 year-olds.  Scott Warren, founder of the Civics-focused non-profit revives the case for moving the voting age down to 16.  There is a lot of tension around the age-related laws with states lowering the age for a charged citizen to be treated as an adult while at the same time raising the age to buy a pack of cigarettes.

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