Investments  

Finding a framework for financial literacy

This article is part of
Winter Investment Monitor - December 2015

Most of us have been caught out at least once by the menu on our smartphone or the option on the app that we couldn’t quite understand.

By pressing the wrong button we might change our phone’s language to Japanese, delete half our contact list, or send great auntie men’s aftershave for Christmas.

But while the costs of poor technological sophistication may be low – after all, auntie might even like the aftershave – the costs of poor financial sophistication can be enormous. Pressing the ‘interest only’ button when we should have selected ‘capital repayment’ could create a mortgage time bomb. Putting all our eggs into one tech-stock basket could be a ticket for a lottery we never wanted to play.

A current buzz phrase in academic and policymaking circles is ‘financial literacy’. It refers to the capacity of individuals to understand fundamental tenets in economics and finance, such as real versus nominal gains, interest compounding and portfolio diversification.

Over the past decade studies have shown many consumers, spanning age groups, educational levels and nations, struggle with even these basic concepts. Recent research based on a representative sample of older Americans found less than half knew the difference between real and nominal gains and less than a third could comprehend compound interest.

Spurred by these worrying findings, a financial literacy agenda has developed across the world. The Organisation for Economic Co-operation and Development has incorporated financial literacy into its international testing of educational achievement, with its own Financial Literacy Taskforce. The UK has a ‘financial capability strategy’. Even the Bank for International Settlements has listed financial literacy as a priority for the global economy.

The issue is of particular importance at a time when governments are increasingly moving responsibility for financial planning and decision-making away from the state and on to the individual.

In the UK, for instance, we are witnessing a revolution in pension flexibility. More widely, deregulation, technology and reduced costs of information are relentlessly opening up new investment and borrowing opportunities – from spread betting to payday loans.

In many cases, consumers do not have the skills to navigate the options available or deal with the new responsibilities thrust upon them. So what should be done?

A common response is to push for financial education, especially among the young. If we can teach the next generation basic finance, then maybe we can give them the skills necessary to thrive in a financially sophisticated world. But there is little evidence that financial education is effective among adults – and at the same time there is much stinging criticism of policy programmes that offer little in terms of value for money.

So is better financial advice the answer? There is certainly emerging evidence that it can compensate for consumers’ poor financial literacy. For example, research at the University of Nottingham showed that credit counselling can go some way to improving the financial literacy among those with high debt burdens.