The less you know about finance the better

October 25, 2010

Everywhere you turn these days, some bigwig policymaker is talking about the importance of financial literacy education. Here’s Ben Bernanke doing it. And there’s Tim Geithner and Arne Duncan. Even the President. It’s easy to understand why we feel like we need this, what with all the bad financial decision-making of recent years. The only problem is, there’s a fair amount of evidence that a lot of what we do to teach better financial habits, like courses in high school, doesn’t work. Some research has shown that financial education is more likely to stick if it’s focused on one topic and comes right before a person makes a related decision—learning about mortgages as you’re house shopping, say, or getting a lesson in compounding interest along with your credit card.

But maybe there’s a simpler approach. Maybe we should ignore real-world complexity altogether and just teach people financial rules of thumb.

A presentation at that microfinance conference last week got me going on this train of thought (although I’m by no means the first to ride it). In this experiment, researchers taught one group of small-time entrepreneurs in the Dominican Republic formal accounting, including double-entry bookkeeping, cash and working capital management and investment decision-making. Another group was taught simple rules of thumb, like “keep personal and business accounts separate” and “write everything down.” The results:

People who were offered rule-of-thumb based training showed significant improvements in the way they managed their finances as a result of the training relative to the control group which was not offered training. They were more likely to keep accounting records, calculate monthly revenues and separate their books for the business and the home. Improvements along these dimensions are on the order of a 10% increase. In contrast, we did not find any significant changes for the people in the basic accounting training. It appears that in this context, the rule-of-thumb training is more likely to be implemented by the clients than the basic accounting training.

When I caught up with Greg Fischer to ask what the U.S. consumer-class take-away might be, he was appropriately modest about his findings and hesitated to draw any universal conclusions. I lack such compunction, so let me say that I think this result contains a very important piece of wisdom. People live complicated, busy lives and the learning they are most likely to put to use is that which is simple to remember and implement. In Fischer’s study, some microentrepreneurs received follow-up training at their place of business: an educator stopped by to reinforce concepts and to answer questions. Once this happened, the group that received the formal accounting training applied what they had learned. But unless we want to set up a system in which your high school consumer finance teacher pops back up just in time for your first mortgage, rules of thumb might be the way to go.

And, actually, we already have many them. We just need to dig them out of the dustbin we tossed them into during the free-money euphoria. For example, don’t spend more than 2 1/2 times your annual salary on a house. And don’t take out more student loan debt than you expect to earn in your first year on the job (assuming you have the option). As Jack Bogle once said: ”Your bond position should equal your age. I won’t tell you this is the best investment advice you’ll ever get, but the number of pieces of advice that are worse is infinite.” It’s not terribly complicated to figure out what we need to teach. We just need to jump to it.


My oldest child graduated from college two years ago. I sat down with him and explained compound interest, the difference between Roth and regular retirement savings vehicles, the 4% withdrawal rule of thumb, and the importance of diversification and expense ratios in mututal funds.

He is currently saving 15% a year in a combination of Roth IRA, 401k, and employer’s match in retirement savings and another 6% per year in regular savings accounts. The retirement investments are going into simple, diversified target date accounts with expense ratios of less than 0.75% per year. The regular savings is currently just in FDIC-insured savings accounts.

If he can continue doing that, he may be able to comfortably retire at age 59-1/2 without worrying about Social Security etc.

You don’t need to know too much more.

Posted by ErnieD | Report as abusive

Basically all you need to know about finance:

1) If you are earning more than the risk-free return someone is taking a risk. If you are a retail player you can be 99.999999999999999% sure it is you.
2) If you don’t understand it don’t buy it
3) Target lifestyle not returns. First thing anyone should do is measure the money they need to have to have the lifestyle they want and then try and find the lowest risk way to hit that return. Too many people have the investment goal of “Make the most money” without focusing on the downside
4) Slightly contradictory to above, if you can’t afford to lose it then don’t bet it.
5) Easiest places to make super-normal risk-free returns are tax planning and paying down debt.

Posted by Danny_Black | Report as abusive

How about this rule of thumb: If you plan to work for 30 years and then live another 30 years in retirement, you need to save roughly 1/2 of your income during your working years. Do the math.

Posted by maynardGkeynes | Report as abusive

The argument for teaching people rules of thumb is even stronger than you think – in the real world which is complex and uncertain, rules of thumb frequently outperform more “scientific” methods as I argued here 8/heuristics-and-robustness-in-asset-all ocation/ . Even Markowitz simply allocated his portfolio equally to all his options rather than running a mean-variance optimisation.

Posted by macroresilience | Report as abusive

Given the desire by students and parents that secondary education be more practical and relevant, it seems that even the most practical and relevant of training isn’t useful unless the timing is right. Go figure.

@Danny: My rule has always been “Don’t measure your lifestyle against that of your neighbors/ friends/ colleagues. The only person you have to satisfy is yourself.”

Posted by Curmudgeon | Report as abusive

@macroresilience: Thanks for the link.

Posted by BarbaraKiviat | Report as abusive

I whole-heartedly agree! There are three basic timeless principles: live below your means, save aggressively, invest conservatively.

Violations of the first principle simultaneously increase your “burn rate” (hard to throttle back) while decreasing your savings stream. Adding interest charges on top of that makes the situation even worse.

Attempts to reverse the latter two (save less and invest aggressively) only work in favorable markets and leave you naked in a crash. As Danny Black says, all investments come with risk. Managing that risk is the most important piece of an investment strategy spanning decades.

I disagree with the simplistic calculation, “If you plan to work for 30 years and then live another 30 years in retirement, you need to save roughly 1/2 of your income during your working years.” You can invest sensibly and still get positive real returns. (I personally believe I can hit 4% real returns with a low-risk portfolio.) That perhaps doesn’t sound like much, but there is a huge difference between saving 20% of your income and saving 50%. The former is likely sufficient if you begin early enough.

Posted by TFF | Report as abusive

You can teach all the financial literacy and encourage Americans to be thrifty and invest prudently, but it’s all meangingless if the Fed destroys the income that should result from our savings via zero interest rate policy, and debases the dollar.

Posted by Sechel | Report as abusive

@TFF: A more realistic real return assumption for the 99% – 100% of mankind who can’t beat the market is the real rate of interest on 30 years TIPS, currently at 1.34%. So yes, on that assumption of a risk free return, my 50% savings is a bit high. I don’t have my calculator handy but, if you assume 1.34% over 30 years you still need to save about 40%. (But even that assumes that real yields will not go lower than they are now, which is not a given, and moreover, you will want to shorten duration as you near retirement, which also means lower yields.). But remember, the question is for a rule of thumb for the average Joe. The answer is to save a LOT MORE than you do now. Why don’t we hear that from our leaders? Because the powers that be don’t want people to save for their retirement — that’s bad for business — so they promise the free lunch of equity returns, home appreciation, and various other magic. So I ask you, how well has that worked out for the average person now nearing retirement?

Posted by maynardGkeynes | Report as abusive

@MGK, we’re in the midst of a bond bubble. Current bond yields are not reflective of the broader investment climate. Moreover, suggesting that a 30-year TIPS is “risk free” ignores the very real possibility of sovereign default. Further argument that the bond market is not being even remotely rational in its pricing.

I can’t offer you a “risk free” investment, but I’ll stand by my suggestion that a 4% “low risk” portfolio is possible. (Though it may be down to 3% after the market run-up this past year? Pricing isn’t nearly as good today as it was then.)

And yes, I agree with your “SAVE A LOT MORE” advice. Guess it is easier to cite a simple 50% figure than to go through the more complicated analysis of dollar-cost averaging over 40 years of a working life.

The average person now nearing retirement has done extremely well — if they’ve bothered to do anything at all. The markets over the last 40 years have offered superb returns, with falling interest rates pushing *bond* returns to levels normally reached only by equity investments. Anybody who spent the last 40 years saving is now quite wealthy. Anybody who didn’t has no excuses.

Posted by TFF | Report as abusive

A household with $50k earnings that saves $10k/yr for 40 years should end up with $600k (2% RR) to $950k (4% RR) when they retire. At a 4% annual draw rate, that provides between $24k and $39k a year of income.

If you can hit a 4% real return for a portfolio over 40 years, then you can replace 100% of your income (after deducting retirement savings) in retirement. However the lower 2% real return is probably still enough to live on, at least if you own your home by then.

A 20% savings rate suffices, you just need to start early.

Posted by TFF | Report as abusive

@Barbara – my pleasure.

Posted by macroresilience | Report as abusive

The problem with personal finance rules of thumb is that they are in economist Larry Kotlikoff’s words, rules of dumb. In other words, they do additional financial harm at least as often as they help.

Also personal finance ‘rules of thumb’ do not hang together in any coherent fashion. It is common to find that when using two or more of these rules they contradict one another. If personal finance was so easy as to be solved by obeying a relatively small set of simplistic rules, the problems of personal finance would have gone away decades ago. People may be dumber than we like to believe, but people aren’t that dumb.

Posted by midnightcowboy9 | Report as abusive

Can you give some examples of contradictions, Cowboy?

Posted by drewbie | Report as abusive

midnightcowboy9, I disagree. I think the issue with the rules of thumb is people don’t like what they say. They WANT to believe that they have found the place where they are taking no risk and getting a high yield. They typically will not hold onto investments long after they should have been sold. etc etc. People make financial decisions like they make other decisions with their emotions.

Posted by Danny_Black | Report as abusive

Rules of thumb are awesome, but the “sell-side” controls them a bit too much in the media and web age.

A realtor or car salesman loves to give you the happy news that you “can” spend so much more.

Posted by jpersonna | Report as abusive

There was no arms waiving. No sulking and skulking around. No driving us supporters mad. It proves that he CAN do it..even when it’s not all in his favour. It’s nothing to do with being languid. It’s called application to the cause.


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