How financially literate are you?
24 November, 2015
A new global survey on financial literacy showing that two thirds of people around the world failed to answer a short test on basic financial concepts. What are the concepts?
The results of the latest survey, which was commissioned by Gallup, the World Bank and the George Washington University, were issued last week and confirmed that just 33% of 150,000 people surveyed around the world were able to correctly answer five questions about four basic financial concepts.
It might be useful to briefly run through the questions so that we can all check our own financial literacy.
The first question relates to diversification: Suppose you have some money. Is it safer to put your money into one business or investment, or put your money into multiple businesses or investments?
The correct answer is of course multiple businesses or investments, in order to spread your risk. But this proved to be the least well understood concept, with only 35% of respondents answering this correctly.
The second question was on inflation: Suppose over the next ten years, the prices of things you buy double. If your income also doubles, will you be able to buy less than you can today, the same as today or more than you can buy today. The answer is the same; that is, if prices double, then as long as your income grows at the same rate then you won't be affected. If price inflation is greater than your wage inflation, your income won't be able to buy as much as it used to.
One point of interest from this question was that the concept of inflation was best understood in countries that had had a recent experience of inflation. Respondents in Argentina, Bosnia and Peru scored very well in this question because their countries have each experienced hyperinflation, with rapidly rising prices.
The third question was a simple one about interest. Suppose you need to borrow $100. Which is the lower amount to pay back - $105 or $100 plus three percent. The answer is obviously $100 plus three percent which equals $103, but in some countries, less than half of respondents answered this question correctly.
The fourth and fifth questions were about compounding. Suppose you put money in the bank for two years and the bank agrees to add 10% interest each year to your account. Will the bank add more to your account in the second year, or will it add the same amount both years? Then, suppose you had $100 in your savings account and the bank adds 10% per year to the account. How much money would you have in your account after five years — exactly $150 or more than $150?
The answer to these questions required respondents to understand the power of compounding which means the interest increases each year because interest is earned on top of interest.
The results of the questions about interest were quite telling. For example, even though one third of American adults have an outstanding loan on which they will pay interest and that interest will compound over time, more than 30% of them don't understand how debt accumulates.
Diversification, inflation, compounding — this is stuff we used to get taught at school?
When asked for solutions or suggestions to improve global financial literacy, academics and researchers said there is no single answer, and it is incumbent on all of us to want to learn and understand financial concepts as we are going to encounter them in life and should prepare ourselves.
They said that mandatory programs needed to be introduced to schools, however, contrary to first reaction, schools will be better to insist on math's classes being taken through senior school rather than financial literacy classes. Their logic is that basic math's understanding helps with basic understanding of financial concepts.
Also, the retention of topics covered in financial literacy classes is only two years at best. This is because the concepts only become relevant when you are for example buying a home or saving for your retirement, so they are quickly forgotten and only drawn on when you need them. As you can imagine, a teacher would struggle to talk to college students about retirement saving yet at some point those students will need to know.
There was also a correlation between understanding of mathematics and financial literacy. Young people in countries such as China, South Korea, Portugal and Vietnam had high literacy and they are also the high scorers in the OECD's standard maths test that 15-year-old students complete.
What about New Zealand. How did we fare?
The good news is that New Zealand fared better than the global average with 61% of respondents passing the test (compared to the 33% global average) and we are only slightly behind Australia which scored 64%. Our gender gap is also smaller than Australia though it is wider than the 5% global average with 66% of NZ men being financially literate versus 57% of NZ women.
The bad news in the survey was that in virtually every country, there is a gender gap in financial literacy, with men scoring better around the world than women except, interestingly in the UK, where women outscored men!
So, interesting survey results that confirm that although NZ citizens are better than most when it comes to financial literacy, we all need to take personal responsibility to understand basic financial concepts.