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Financial literacy impacts decision making

Research by the US Federal Trade Commission shows that financial education affects financial decision-making. Failure to plan for retirement, lack of participation in the stock market, and poor borrowing behavior can all be linked to ignorance of basic financial concepts.

Some of these findings, from the 2008 paper Financial Literacy: An Essential Tool for Informed Consumer Choice? by Annamaria Lusardi, may seem quite obvious at first glance. For example, the author points out that those who demonstrate even a basic understanding of relevant financial topics are much more likely to have planned for retirement. These are not sophisticated topics, but basic things such as knowledge of interest compounding and the ability to perform simple mathematical calculations . Skills like these were shown to be among the strongest predictors of successful retirement planning.

To appeal to the average person, who may not have had a lot of prior exposure to financial topics or investment experience, the study suggest a social or even a psychological approach to financial education, for example exploiting “teachable moments” like the beginning of a new job, in order to get a person to think about taking action when their minds are open to new ideas about how financial decisions may affect their lives.

While the points raised by this study are reasonable, the challenge faced by society, even wealthy countries, is vast. Since the late 1980s when there were significant changes in laws regarding retirement planning, companies were much more free to move from traditional defined benefit plans like pensions to defined contribution plans like 401K plans that shift the responsibility of planning from the corporation to the individual.

While individuals and organizations with high levels of financial sophistication, such as firms specializing in industry specific areas such as chemicals m&a experts can easily manage rather exotic financial decisions, the average person has a much more difficult situation. Financial instruments have become increasingly complex and individuals are constantly being bombarded by the investment industry with new and financial products. However, most individuals are not well equipped to make financial decisions.

The study showed that most individuals cannot perform simple calculations and lack knowledge of basic financial concepts. Knowledge of more complex concepts, such as the difference between bonds and stocks, how mutual funds, and how to estimate the value of an asset is even rarer. Financial illiteracy is widespread among the general population, and particularly evident in some demographic groups that happen to also be overrepresented among the poor and struggling working class, such as women, African-Americans, Hispanics, and those with low levels of formal education.

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