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The importance of financial literacy.

Article Excerpt
How much do individuals know?

Increasingly, individuals are in charge of securing their own financial well-being after retirement. With the shift from defined benefit to defined contribution pensions, today's workers must decide both how much to save and how to allocate their retirement wealth. Financial markets have become more complex and individuals are faced with a proliferation of new investment products. Investment opportunities have expanded beyond national borders, permitting individuals to invest in a broad range of assets and currencies. However, as the financial crisis has made clear, it is very hard to navigate this new financial system, and the consequences of mistakes can be devastating. How well equipped are individuals to make financial decisions and how much do individuals know about economics and finance?

Very few datasets provide information about financial literacy, and those that do often do not have any facts about saving and financial decisionmaking. To address this, Olivia Mitchell and I designed a module on financial literacy for the Health and Retirement Study (HRS), a survey that provides information on people 50 and older. (1) We aimed to assess their knowledge of basic concepts that lay at the basis of saving and portfoliochoice decisions, such as interest compounding, inflation, and risk diversification. The results from that initial module were striking: only one-third of respondents could do simple inter est rate calculations and appeared to understand the effects of inflation and the workings of risk diversification. What is surprising is not that people lack financial knowledge, but rather how little people know about basic economic concepts. Financial illiteracy is not only widespread but is particularly severe in certain demographic groups. Two groups that stand out from our analysis are the elderly and women; both of them display very low knowledge. (2)

These findings are not unique to this survey or to this particular age group. We have confirmed these findings using different datasets, different methods of data collection, and different age groups. For example, we find low rates of numeracy among younger individuals (Early Baby Boomers) (3) and in the entire U.S. population. (4) Moreover, such results are not limited to the United States. With several co-authors, I examined financial literacy in the Netherlands using the same questions that I used in the U.S. HRS. (5) Like American households, Dutch households also exhibit fairly low levels of financial knowledge. (6)

Together with Peter Tufano, I also have assessed financial knowledge...

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