Mar 30, 2017

Which Personal Finance Concepts Cause the Most Confusion?

Skimming the recent GFLEC and the TIAA Institute Personal Finance Index (P-Fin Index) Report. So, let’s start with what’s different about this report:

  • Asked more questions than you would typically find in a financial literacy research report. 28 questions were asked on 8 different topics (3-4 questions per topic):
    • Earning
    • Consuming
    • Saving
    • Investing
    • Borrowing/managing Debt
    • Insuring
    • Comprehending risk
    • Go-to information sources

This is the most instructive chart as it shows the areas of greatest weakness:

Screen Shot 2017-03-25 at 9.07.46 PM

Isn’t it fascinating that respondents answered the most questions correctly about borrowing (61%), consuming (53%) and saving (53%). As for the topics where respondents had the least knowledge: Risk (39%), Insuring (44%) and Investing (46%).

The report also provides several questions that the participants were asked:

  1. Saving question: Anna saves $500 each year for 10 years and then stops saving additional money. At the same time, Charlie saves nothing for 10 years but then receives a $5,000 gift, which he decides to save. If both Anna and Charlie earn a 5% return each year, who will have more money in savings after 20 years?

Anna (correct answer; chosen by 44% of young adults)

■ Anna and Charlie will have the same amount (chosen by 22% of young adults)

■ Charlie (chosen by 6% of young adults)

■ Don’t know (chosen by 27% of young adults)

My take on the question: Given where interest rates are today, I might have mentioned that this money was invested in the stock market or a portfolio with stocks and bonds since a 5% return on savings accounts cannot be achieved. I think its important for consumers to understand that in order to earn a return that will keep up with inflation requires taking on some risk in the form of stocks and bonds. Also, given that the time frame is over a 20 year period that makes even a strong argument for such a portfolio.  

_________

2. Risk question: There’s a 50/50 chance that Malik’s car will need engine repairs within the next six months which would cost $1,000. At the same time there is a 10% chance that he will need to replace the air conditioning unit in his house, which would cost $4,000. Which poses the greater financial risk for Malik?

The car repair (correct answer; chosen by 41% of respondents)

■ The air conditioning replacement (chosen by 19% of respondents)

■ There is no way to tell in advance (chosen by 19% of respondents)

■ Don’t know (chosen by 20% of respondents)

My take on the question: I am not sure how many of us 1) can calculate expected probabilities for events in the future (and if we did we wouldn’t be very good at it) and 2) can estimate what the cost of such occurrences would be. Since we can’t do either of these things well, we need an emergency savings account to buffer us. Bottom line for question #2: If Malik doesn’t have emergency savings then either event creates financial risk. The questions lends precision to risk analysis that doesn’t exist in our day-to-day lives.

__________

3. Borrowing question: Jose owes $1,000 on a loan that has an interest rate of 20% per year compounded annually. If he makes no payments on the loan, at this interest rate, how many years will it take for the amount he owes to double?

Less than 5 years (correct answer; chosen by 43% of respondents)

■ 5 to 10 years (chosen by 20% of respondents)

■ More than 10 years (chosen by 8% of respondents)

■ Don’t know (chosen by 28% of respondents)

My take on the question: Rule of 72 provides a good shortcut to answer this problem. This appears to be more of a numeracy problem than a test of financial literacy. My follow-up question might be focused on how Jose might use this information of how compounded interest can work against you and apply it to his borrowing behaviors. Perhaps the other questions are more on the application side.

___________

My vision for an assessment of financial literacy moves beyond multiple choice tests to include critical thinking, asking the right questions, conducting research, analyzing data and ultimately making a decision and describing the rationale for it. Another item to add to our product roadmap:)

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

Mail Icon

Subscribe to the blog

Join the more than 11,000 teachers who get the NGPF daily blog delivered to their inbox: