Although managing personal financial matters can become complex, the application of just a few basic, easily understood principles can prevent most financial calamities. And while these principles are neither new nor revolutionary, the majority of Americans keep making the same mistakes.
The value of taking control of personal finances is indisputable. A study by the Certified Financial Planner Board of Standards revealed that middle-income families with even an informal financial plan lived more comfortably, were more confident about managing money and were more likely to keep pace with financial goals than those without a plan. Those with a plan were more likely to have 10 months of savings, were more likely to pay off credit card bills each month and were less likely to declare bankruptcy. Research from Morningstar shows that individual investors earn annual returns about 2.5% lower than the funds in which they invest because they are unnecessarily and unsuccessfully moving among investments trying to find some advantage.
It’s not as if there are no available resources for these basic principles. Financial journalists have put forth the importance of living within one’s means, saving for long-term goals and establishing simple investment portfolios in every way imaginable. They have also stressed hidden costs and risks of financial products and have implored investors to understand how financial advisors get paid. Financial regulators regularly release alerts and warnings regarding specific products and practices. There are plenty of free online tools to analyze everything from investing to mortgages to college financing to saving, and on and on.
Plenty of professional and non-profit organizations have taken on the challenge of financial education. Most community colleges and cooperative extension services, among other agencies, offer free financial courses. Certified public accountants have two initiatives to help create a path to financial stability, www.360financialliteracy.org and www.feeedthepig.org. The National Endowment for Financial Education, an offshoot of certified financial planners, offers youth and adult financial education and training tools. The Charles Schwab Foundation provides direct grants to selected nonprofit organizations that support financial literacy. Dave Ramsey’s Financial Peace University, which promotes debt-free living, is available for a nominal fee across the country. The Personal Finance Employee Education Foundation has developed research showing that providing financial education to employees improves a company’s bottom line by improving personal financial behaviors and job performance. Even Bank of America has partnered with Khan Academy, whose goal is to provide free educational resources to students, teachers and adults, to present the “why” and “how” behind personal finance.
So, why the disconnect between common knowledge and behavior? First and foremost, it is an open secret that the financial services industry has a massive financial interest in keeping things as complicated as possible. They counter the “keep it simple” approach by adding new wrinkles and features and employing terminology that only serve to confuse rather than to enlighten or educate. The goal is to perpetuate the idea that there is some special knowledge or magic that only they have, and if you pay them enough they’ll let you in on the game. Once you’re in, the only real advantage goes to the industry, but it is incredibly difficult to figure that out.
The industry also has far more resources, creativity and determination to counter any education movement. Banks and credit unions have long offered costly investment services to customers who, despite disclaimers to the contrary, assume that it must be okay if it is available right in the bank lobby. (In this environment of low interest rates, bank customers are even more susceptible to being enticed into something that offers the potential for higher returns but also the unsettling risk of loss.) Although it does air some responsible personal financial advice, CNBC serves mostly to strengthen the mystique of the industry; the network has annual revenues of more than $500 million and profits of over $300 million. Companies unabashedly market to fear and greed and consumers are unequipped to resist. One company is testing kiosks in Wal-Mart with a $5 card to activate the first month of life insurance.
The biggest hurdle is that most financial decisions are made on an emotional rather than an intellectual level, and there are also cultural norms that cloud financial judgment. We are undoubtedly a consumer society and the temptation to keep up with the Joneses is incredibly strong. The availability and ease of use of credit is a problem; consumers spend 12-18% more when using credit and focus on the benefits rather than the cost. A review of various studies by the University of Cambridge concluded that basic financial habits are largely set by age 7, so families pass on their bad habits to their children. The scariest study was from T Rowe Price in which children of ages 8 to 14 were asked the most likely ways to have a million dollars when they grow up. Savings accounts and investments garnered 53% of the responses, but becoming famous came in at 24% and winning the lottery at 18%.
Impulse control and delayed gratification are weak; in the famous “marshmallow study” children were offered one small reward immediately or two rewards if they could wait 15 minutes until the researcher returned, and only about 1/3 were able to defer gratification long enough to earn the second reward. The “head in the sand” approach that everything will be okay is very dangerous; the cumulative effect of seemingly innocent financial mistakes can be huge. And hedonism, or the devotion to pleasure and the pursuit of happiness as a way of life, is a sure ticket to financial ruin because there always has to be more.
Some argue that personal finance should be explicitly taught in schools; others feel that schools are already stretched too thin, and if schools want to use personal financial examples in teaching math that would be fine. Like most behavioral problems, individuals must first acknowledge that there is a problem and decide that they want to change. The difference with financial issues is that the solution is almost entirely within their grasp.