Sunday, October 6, 2013

Personal finance education can be good, but is typically poor

Eminent Chicago behavioural economist Richard Thaler wrote Saturday on the poor effectiveness of typical personal finance education, "It would be premature to conclude that all efforts at improving financial literacy are futile. But it is a fair conclusion that simply doing more of the training commonly used now will not produce significant results. So what else might we try?"

I have long written that the vast majority of personal finance education is very poor, and I've been teaching it at the University of Arizona continuously since 2005. The great Harvard financial distress expert Elizabeth Warren has written the same thing. Below is a quote from her seminal personal finance book, "All Your Worth". I believe "All Your Worth" gave birth to good modern American personal finance, and I've assigned it cover-to-cover since it first came out in 2005. But, sadly, I'm one of the only personal finance instructors in the country to use that book, or even the core Balanced Money Plan in it. Here's the quote:
The Two Income Trap did more than raise some public policy issues; it touched a raw nerve. We would be going about our business, and then, out of the blue, someone – a neighbor, a caller to a radio program, a mom dropping off her son at preschool – would pause and say quietly, “You’re not just talking about money, you know. You’re describing my entire life.” And then the voice would drop to an urgent whisper, “No one knows how much I worry about money. What should I do?”

Of course, we gave the best answer we could. But how much could we really say in the grocery store checkout line or in the 90 seconds allowed to a radio caller? Over time, those conversations began to haunt us. Whenever we had a quiet moment, we would think about the people who had asked us for help. Sure, America needs policy changes, and in time maybe we’ll get some laws that make more sense. But in the meantime, what should people do?

At first we thought the answer would be really easy – just find a couple of good books we could recommend. So we started looking for a great book that would help ordinary people get control of their money.

And we looked.

And looked.

Everywhere we went we found pretty much the same thing. Plenty of books on the difference between bull and bear markets, and lots of tips on how to find a great deal in potato futures. In other words, we found oodles of advice for people who are financially secure and just want to make a little more money. But what about people who aren’t so secure? What about the people who stopped us in the grocery store, the mothers at the preschool, and the guys at Home Depot? Where was the advice for them?

It didn’t exist, so we developed All Your Worth. (pages 6-7)
In 2009, I was asked to do a chapter review for the Springer book, "Consumer Knowledge and Financial Decisions" (2012). In it, I wrote about the terrible state of personal finance education, and what would constitute good effective personal finance education. I agree with all the suggestions Professor Thaler offered in his op-ed, and long incorporated them into my courses, as did Professor Warren in her book. To show you that I've thought this for a long time, I'm going to print an excerpt from that chapter review verbatim, as it was in 2009, with no modification, even though for a post like this, rather than a specific reply to a chapter, I'd like to modify and improve it, and I'd like to add what I've learned in the last four years. But, I'll have more posts on this. For now, as I wrote it in 2009:
4) Personal Finance is taught very poorly today – Now we get to the biggest issue: For the vast majority of personal finance textbooks, popular books, courses, and materials I have seen (and that's a lot), even if you learned it 100%, it would improve your personal financial success very little, and it would decrease your odds of personal financial distress, or ruin, very little.
It's just full of trivia, vagueness, things of little value to personal financial success, and avoiding personal financial distress or ruin, and vague, poor, or even dangerous advice. I think this is partly due to the fact that good personal finance has changed greatly over the last generation or two but what is taught has changed little.

America is far riskier and more dangerous financially than in the past: 
-- Regulation a generation ago prevented very dangerous tricks and traps. 
--Excessive prestige/positional arms races were prevented by bank regulation leading to strict lending limits for homes, cars, etc.  
--The social safety net was stronger, and employment was much more secure.  
--There was usually a second earner in reserve in case the husband lost his job. A stay at home wife could also care for the ill, with no family income loss.  
--Medical insurance was far cheaper, and far more secure. In addition, the co-pays and deductibles were far lower.  
--Most people had guaranteed pensions, not voluntary, you invest, 401Ks, or nothing.
 and more 
As a result, advice like, just clip coupons and eat less steak, worked in the past because it was not possible to grossly overspend on large fixed expenses, and financial life was much more secure. You could teach trivia and little things then, and it didn't matter nearly as much as it does today.

This is also, by and large, the opinion of Harvard bankruptcy and personal finance expert Elizabeth Warren. Professor Warren writes in her 2005 book "All Your Worth" (which I think is by far the best personal finance book available today, and which I assign to my students cover-to-cover):
The Two Income Trap did more than raise some public policy issues; it touched a raw nerve. We would be going about our business, and then, out of the blue, someone – a neighbor, a caller to a radio program, a mom dropping off her son at preschool – would pause and say quietly, “You’re not just talking about money, you know. You’re describing my entire life.” And then the voice would drop to an urgent whisper, “No one knows how much I worry about money. What should I do?”

Of course, we gave the best answer we could. But how much could we really say in the grocery store checkout line or in the 90 seconds allowed to a radio caller? Over time, those conversations began to haunt us. Whenever we had a quiet moment, we would think about the people who had asked us for help. Sure, America needs policy changes, and in time maybe we’ll get some laws that make more sense. But in the meantime, what should people do?

At first we thought the answer would be really easy – just find a couple of good books we could recommend. So we started looking for a great book that would help ordinary people get control of their money.

And we looked.

And looked.

Everywhere we went we found pretty much the same thing. Plenty of books on the difference between bull and bear markets, and lots of tips on how to find a great deal in potato futures. In other words, we found oodles of advice for people who are financially secure and just want to make a little more money. But what about people who aren’t so secure? What about the people who stopped us in the grocery store, the mothers at the preschool, and the guys at Home Depot? Where was the advice for them?

It didn’t exist, so we developed All Your Worth. (pages 6-7)
To illustrate why I think personal finance education is so poor today, I'm going to list what I think are the most important things that should be taught in personal finance. Then, I will show how poorly the widely used Jump Start survey/exam tests for those things.
Most Important
i. Budgeting – Fixed costs less than 50% of after tax pay, savings at least 20% (Harvard professor Elizabeth Warren's Balanced Money Plan in her book, "All Your Worth")

ii. Counting the dollars is far more important than counting the pennies – For the vast majority of people clipping coupons and cutting back on the lattes won't come close to making up for overspending on home and vehicles. The big expenses have got to be taken care of first and foremost. This is the largest problem in personal finance today. Family fixed expenses have gone from an average of 54% of after tax income in 1972 (with a potential second earner housewife typically in reserve) to 75% even with two earners (Warren, 2007). This leaves only 25% that can be cut back quickly to weather a job loss or other crisis without resorting to destroying savings and then possible a debt spiral (my play on the accounting term death spiral). With fixed expenses (including basic food, all fixed expenses) instead at 50% or less, a family could probably just cut back on discretionary expenses and get by on the other spouses income and unemployment without touching savings. The destruction of savings and a debt spiral is unlikely.

iii. Understanding and Handling Well Positional/Context/Prestige externalities

iv. Investing – Well diversified stock portfolio like Wilshire 5000 for money you won't need for at least 10 years, and won't need a lot for at least 20, TIPS, dangers of non-government backed bonds, inflation danger of long term bonds even if they are government backed, paying off mortgage faster a great safe investment, no home equity loans, making sure you have enough safe liquid money.

v. Real Estate – How much to spend on a home, thinking of it as an expense, not an investment, avoiding bubbles, avoiding mortgage and other traps, when to buy, when to rent, the breakeven period for home buying and selling costs, when to wait longer and keep renting for a larger down payment, better credit, and therefore a much lower mortgage rate, all of the costs of a home, not just the mortgage payment, a small apartment will allow more wealth creation than a large house if the savings from rent being less than the mortgage payment, from not having a downpayment, from not paying for maintenance, etc. is put into savings like a Wilshire 5000 type fund and TIPS, the average home price appreciation is less than inflation when including maintenance, insurance, etc., and so on.

vi. The exponential growth of compound return, and the power of saving – The curve is ski sloped shaped, not a straight line, so great wealth can be amassed over the long run with just steady moderate saving. How this power can work against you when taking out debt.

vii. The biggest and most dangerous tricks and traps: Private student loans, home equity loans, extreme sub-prime mortgages, the most exorbitant and dangerous for profit schools, fringe economy businesses/services/scams, etc.

viii. Diversification – Not just in stocks, also as a general concept, diversifying with a paid for home, with not having most or all savings in a small business 401K, which unfortunately have little government protection, with having no debt, with flexibility and good relationships with family and friends, etc.

ix. Education and careers – The value of a college degree, the value of training, that it's not just about money, with good personal financial practice you can be financially secure and much happier in a lower paying career that you enjoy more, than you would be in a higher paying career that you enjoy less, or in a career whose hours allowed little of a family or personal life, the volatility of career pay today so be careful about raising your expenses automatically in proportion to pay increases, researching the careers you're interested in.

x. Bankruptcy – It's something that's important to know and consider in today's far less secure world. It can prevent a lifetime of constant financial distress and oppression, and having poverty and suffering linger unnecessarily for many years or decades, the purpose of bankruptcy, why the founding fathers made sure to put it right in the constitution.

xi. Handling crises well and understanding that in today's far less secure America, they are not that unlikely to occur in your lifetime – Knowing how to handle crises well can prevent destroying all savings, and after that a debt spiral. Don't wait until you exhaust your savings and have resorted to debt if you're unemployed, etc., instead act very early and proactively in the crisis, slash expenses, move in with your parents, etc., very quickly, do not cash out home equity and retirement accounts if it looks like medical bills, or any crisis, will lead to bankruptcy anyway, instead declare bankruptcy before cashing out those things as you can keep most or all of them in bankruptcy.

xii. Insurance – Health, term life, liability, disability if reasonable (which is often), the concept of insurance; it's a negative average return, so only for catastrophic, or very difficult, losses.

xiii. The fact that good personal finance has changed greatly over the last generation or two so be careful of the older advice – America is far riskier and more dangerous financially than in the past when regulation prevented very dangerous tricks and traps, excessive prestige/positional arms races were prevented by bank regulation leading to strict lending limits for homes, cars, etc., the social safety net was much stronger, employment was much more secure, and there was usually a second earner in reserve in case the husband lost his job, a stay at home wife could also care for the ill with no family income loss, medical insurance was far cheaper and far more secure, in addition the co-pays and deductibles were far lower, most people had guaranteed pensions, not voluntary, you invest, 401Ks, or nothing, and so on. As a result, advice like, just clip coupons and eat less steak, worked in the past because it was not possible to grossly overspend on large fixed expenses, and financial life was much more secure.

Next Most Important
i. The importance of good relationships and handling money issues with loved ones well – Good cooperation and coordination is valuable for the personal financial success of couples. Divorce can be devastating to one's personal finances (of course sometimes people are just not compatible, or a spouse is abusive). It's far more expensive for two people to live separately than together. In addition, diversification is decreased greatly when we live singly, and when we don't have close friends and loved ones who can help us weather crises; being able to move back in with parents, and have it be mutually enjoyable, can be extremely valuable for weathering unemployment and other crisis without destroying all savings and/or beginning a debt spiral.

ii. The importance of good nutrition, fitness, and other health and safety practices to personal financial success – Illness, which includes accidents, is the number one cause of bankruptcy. Better health means better and more secure employment. Smoking can cost as much, or more, than transportation in cigarette purchase costs alone. Poor driving can lead to thousands of dollars per year in ticket and excess insurance costs, and it can lead to an accident whose medical bills and lost work can easily bankrupt you even with health insurance; it can cause you to miss so much work that you lose your job, and it can leave you with a permanent disability.

iii. The how much to work after childbirth decision – Do you, or do you not, really make much or any more money working after childbirth when considering everything, daycare costs, extra transportation, eating out more, taxes, etc. At the same time, there is a danger for a woman staying out of the workforce for many years; her earning power stagnates, or declines, when it might have increased greatly over five, ten, or more years. If a divorce occurs, she may be in trouble financially with little earning power.

iv. Great enjoyment of life with little or no money – Sports, bridge, chess, and other games, many hobbies, nature, reading, music, learning an instrument/creating music, with a $300 electronic keyboard you can play almost any instrument, and the keyboard will have a built-in recording studio; it should also last for decades, social connectedness and romance, family memberships at tennis/recreation clubs can be inexpensive, and more.

v. How to be a smart shopper in general, especially for the big items – The importance of smart comparison shopping; it's especially worth your time for the large items, home, mortgage, vehicles, childcare, insurance, the great saving power of buying used, especially with cars (and how to buy and maintain used cars well), and furniture, but also many other things, especially in the eBay, craigslist era.
Please stay tuned for more posts on this, but let me just note for now, how I, and Elizabeth Warren, advocate for simple rules of thumb, like Thaler suggests, and understanding just basic intuitions, nothing complex, long, or hard to understand and maintain in you memory, things like Professor Warren's foundational, no more than 50% of income spent on "Must-Haves" (basically fixed and necessary costs) and the short memorable intuition why (good intuition, itself, tends to be very memorable, much more so than rote), and the memorable intuition why diversification makes sense in stocks, and in general.