Why financial literacy matters

The first quote is from a report prepared by Professor Saul Schwartz of Carleton University for the Institute for Research on Public Policy (IRPP). The second is from the report issued by the Task Force on Financial Literacy which was appointed by the federal government. Two views of the usefulness of financial education and literacy. Both are from Canadian sources. Both were published in December 2010. Two sharply opposing views.

What gives? Does financial literacy matter? Does it have any effect on how Canadians make financial decisions? Does it do anything to help investors cope with the emotional volatility that sometimes prompts them to abandon a carefully thought-out investment plan in times of market volatility? Are financial advisors wasting their time in trying to educate their clients and are their clients wasting their time trying become financially literate?

Before delving into the questions, some definitions and context are in order.

‘Financial literacy’ means different things to different people, ranging from the most basic knowledge – what is a bank account, what is an interest rate – to a sophisticated knowledge of financial markets and investment vehicles. It’s fair to assume that almost every, though not all, Canadian investors have the basic knowledge. Not surprisingly, the level of financial literacy and knowledge decreases as the complexity increases. But, that leads to another question implied in the quote from the IRPP paper: do they really need it? The answer to that involves a second issue – arguably the most important – which is financial capability or the ability to use financial knowledge to make good financial decisions. All the financial knowledge in the world doesn’t do any good, if the outcome is anything other than good financial decisions.

Professor Schwartz appears to view financial literacy as a ‘nice to have’ at best. His paper cites a number of studies that conclude financial education doesn’t (necessarily) lead to financial capability, i.e., noticeably better financial outcomes for that same group.

The IRPP study conclusion is that since financial literacy apparently doesn’t do much, or in some cases, any good in terms of financial decision-making, the government should provide a legislative/regulatory environment in which the consumer doesn’t need to be financially literate for good financial outcomes.

The report of the Task Force on Financial Literacy defines financial literacy as “…having the knowledge, skills and confidence to make responsible financial decisions.” To the extent that it doesn’t look at the same studies as Professor Schwartz does, it doesn’t cover exactly the same ground as the report prepared for the IRPP. Implicit in the Task Force’s work is the understanding that the greater and more widespread the existence of financial literacy, the greater and more widespread the existence of ‘responsible financial decisions’. And in one very important area, the Task Force Report does answer one of Professor Schwartz’ objections to the efficacy of financial literacy.

Professor Schwartz points out studies conclude financial education doesn’t stick in the recipients’ minds for very long. If you study it in secondary school, the odds are that by the time you are making serious financial decisions ten years down the road, you will have forgotten much or all of what you previously learned. The Task Force Report implicitly answers this objection by including ‘life-long learning’ as one of the essential principals for financial education.

Whatever your views of Professor Schwartz’ paper, it is important to note that many—and perhaps most—of the people who shape pension policy in Canada also see a disconnect between financial literacy and good financial decisions and have virtually no expectation that this disconnect will ever close. That thinking is shaping pension policy in Canada in important areas such as the proposed pooled retirement pension plans.

So, where does this leave us? More particularly, where does it leave financial advisors and their clients? In my opinion, neither report gets it completely right. Professor Schwartz takes too pessimistic a view of the role of financial literacy and how it could help investors. And, despite some excellent recommendations, including one of accountability for the results of financial education, the Task Force Report spends too little time on the final outcomes—good financial decisions.

We know that Canadians don’t always make good financial decisions. If it were otherwise, why would the annual Fidelity Retirement Sentiment Survey show year after year that only about a quarter of Canadians both retired and not yet retired have a written retirement income plan? Why would so many Canadian investors bail out of their long-term investment plans whenever there is a bout of market volatility? Why would so many Canadians put such a large proportion of their assets into residential real estate and/or take on so much debt to do so, especially at or near the end of a long run-up in prices?

The apparent disconnect between financial knowledge and hopefully good financial decision-making is nothing new for financial advisors. They understand that their role includes both basic and more advanced financial education which leads to the creation of a goals based plan. They know that one of their most crucial roles is to persuade a client to act on their plan once constructed.

They know that too much choice can simply confuse and hinder the decision-making process. They know that in periods of market volatility they must communicate with their clients to keep them on track. Fidelity’s annual Retirement Sentiment Survey confirms that clients appreciate it! They know about the resources and investment products that will help with, or make, the decisions about asset allocation, sector and geographic investment decisions.

Let’s consider another aspect of the disconnect. It relates to the age-old saying “a little knowledge is a dangerous thing.” The problem is that every investor has a little knowledge. It can’t be otherwise in an age when the financial information is everywhere. Being everywhere means having constructed an infrastructure that must be used, but not necessarily used well. Once again, the financial advisor needs to step in.

Let me give you an example on why I’ve long been an advocate for financial literacy. I read a recent story in the financial section of a major Canadian newspaper that gave the following explanations as to why the price of crude had risen yet again:

1. a fall in the foreign-exchange value of the US dollar;
2. continued political uncertainty in Libya and the resulting restriction of crude oil supplies;
3. the raising of its benchmark interest rate by the European Central Bank; and
4. the earthquake in Japan on April 7.

The problem with this explanation—and you don’t need a Phd. in economics to get it—is that only the first two explanations had the slightest thing to do with the run-up in crude oil. In fact, the last two would, if anything, contribute to a lower crude oil price by restricting demand.

So what ends up happening? The investor reads something in the news and it creates the urge that he/she should act on it. That is where the importance of financial literacy comes in. At the minimum, it will enable the financial advisor to have a literate conversation with the investor and the reasons why action should or should not be taken. It will be a conversation with some level of subject knowledge equality, which is much more likely to lead to a good investment decision.

So, to answer the questions I asked at the start of this column. Financial literacy does matter and will affect the way investors make decisions. Education is never a waste of time, though it may take years of effort to get it to a level where you want to be.

Even if we accept Professor Schwartz’s conclusion that “financial education has, at best, modest positive effects on savings and financial planning”, should that not be viewed as a positive first step in longer journey towards an acceptable level of financial literacy for all Canadians?

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada.