Wikinvest Wire

Is more financial advice the solution?

Sunday, January 18, 2009

In this op-ed piece in today's New York Times, early housing bubble spotter and Yale economics professor Robert Shiller advocates a massive effort to improve the sorry state of financial literacy in the world.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.
The significance of this was clear at the annual meeting of the American Economic Association this month in San Francisco, where several new research papers showed the seriousness of consumer financial errors and the exploitation of them by sophisticated financial service providers.

A paper by Kris Gerardi of the Federal Reserve Bank of Atlanta, Lorenz Goette of the University of Geneva and Stephan Meier of Columbia University asked a battery of simple financial literacy questions of recent homebuyers. Many of the respondents could not correctly answer even simple questions, like this one: What will a $300 item cost after it goes on a “50 percent off” sale? (The answer is $150.) They found that people who scored poorly on the financial literacy test also tended to make serious investment mistakes, like borrowing too much, and failing to collect information and shop for a mortgage.
The fact that he felt compelled to provide the correct answer of $150 makes you wonder just how bad things really are out there today...

He goes on to talk about all the wonderful improvements that could be made in the world through better education in personal finance and, while this would surely be a good thing for the basics like buying a car, buying a home, or managing the monthly budget, carrying this initiative over in to the investment area is an entirely different can of worms.

Yes, it might have helped if people had actually understood that their mortgage payment would skyrocket in a few years, but the idea of some government sanctioned investment asset allocation seems preposterous.

And avoiding the pain and suffering of the next housing bubble, whenever it might come in 2020, 2025, or later, well, that's just ridiculous.
If personal financial advisers had been subsidized years ago with the best incentives, they still might not have stopped their clients’ bubble thinking during the boom. Many advisers probably thought that housing investments were a good bet. But it’s still likely that advisers who built long-term relationships with their clients, and who pledged to look after their welfare, would have been a helpful influence, suggesting caution to those who were getting over their heads in debt, and warning that adjustable-rate mortgages could be reset upward, just as the fine print said. For these reasons, financial advisers probably would have reduced the severity of the housing bubble.
Nah! That's not likely.

Those urging caution would have been outnumbered ten-to-one by those espousing what was clearly the conventional wisdom at the time - home prices only go up.

I'll never forget the guy from Citibank who, back in 2005, told a room full of engineers that the home equity they had accumulated thus far in the housing bubble process (no, not his words) was, in fact, "dead money" (yes, these were his words) and that it should be "tapped" and then put to work by buying investment real estate.

As for the retirement planning/investment choices side of things, those of you who have seen the PBS Frontline documentary, "Can you afford to retire", might remember Brooks Hamilton, the corporate benefits consultant, who, on one hand, praised 401k retirement plans for the control and flexibility they provided to employees, a small number of whom are sharp enough to navigate their way successfully through the contemporary investment landscape (up until last year that is).

For most plan participants, however, he summed up the situation thusly:
I used to ask the CEO, CFO of my major clients, often in an environment, a conference room­ where some young employee would bring in coffee and all, and as they would be leaving, I would ask the CEO, "Fred, let me ask you, would you allow that employee to direct the investment of your account in the 401(k) plan?" And they always thought I was some kind of idiot. It's kind of like, "Don't they teach you anything down in Texas, Brooks? Of course not. I wouldn't let them touch my account with a 10-foot pole." And I'd say, "Well, but you force them to manage their own, and they are running their money into the ground."
No amount of education is likely to improve the situation for most people - just think of how the guy who comes in to empty the trash at night is doing with his 401k.

Save for the simplest stuff like understanding car loans and home mortgages, maybe a better solution would be to rethink the entire financial system - how it's so prone to making big, giant bubbles that end up hurting a lot of people.

Either that or find some way to lay the investment risk off onto someone or some group who is far better able to handle it than your typical 401k plan participant.


This week's cartoon from The Economist:


donna said...

How about just teach a personal finance class for all high school kids? That would be my suggestion.

Tim said...

Some good comments in the Letters to the Editor section of the WSJ:

In the article "Big Slide in 401(k)s Spurs Calls for Change" (page one, Jan. 8), 35-year-old project manager Kristine Gardner says in response to the 44% drop in her 401(k) last year: "There's just no guarantee that when you're ready to retire you're going to have the money." Newsflash: Higher returns are the compensation for incurring risk, and lower returns are the price of safety. Ms. Gardner's 401(k) would have been completely safe had she shifted her investment allocations into money markets. As money markets yield a paltry 1%, Ms. Gardner's real complaint isn't that 401(k)s are unsafe, but rather that financial markets require her to incur risk in exchange for being compensated for incurring risk.

Retirement consultant Robyn Credico claims that "This is the biggest test that the 401(k) plan has seen . . . and it has failed." Au contraire, 401(k) plans have worked exactly as designed. It is the workers (and their retirement consultants) who have failed. There is only one reason why the average person close to retirement should have lost 50% of his 401(k): incompetence. Most workers at that age should have long since shifted the bulk of their 401(k)s into bonds and money markets. The 401(k) is a powerful investment tool but can be dangerous when abused.

If you aren't willing to put forth the effort to learn the principles of investing, that's your choice. But don't hobble the rest of us by asking for government regulation of a tool that works perfectly well just so that you can be spared the effort of figuring out how to use it.

Antony Davies, Ph.D.
Associate Professor of Economics
Duquesne University

Now, if we all had a Ph.D. in economics, we'd be much better off.

little larry sellers said...

In response to Antony Davies' WSJ comment: while I agree that many Americans have harmed themselves through financial incompetence, the last thing we need are more PhD Keynesians running around. They are perhaps the most delusional people in the entire world, in any academic field. I agree with the spirit of his point, but most universities provide economic indocrination, not education. Same goes for most financial planners.

Besides, we've seen endless hordes of "experts" get blindsided by the current state of the economy too. Even worse, they're still being paid to dispense financial advice!

little larry sellers said...

Oops, just saw the PhD comment was added by Tim, not Davies. I've been reading the blog long enough that my sarcasm detector tells me it was tongue in cheek... I hope!

Tim said...

No, I was serious - the most reasonable solution is that we all get PhDs.

little larry sellers said...

I was trying to be humorous with the "I hope" bit, but you might be on to something here, Tim. It's a way to keep us all busy and employed with government funding. As a grad school dropout, I remember all too well the abysmal effort to reward ratio in graduate studies. I once had a stipend of $20 per month, no joke (with tuition waiver included, at least). Even better, we can gradually learn to disbelieve our own eyes and realize that bailouts are the answer to every problem!

Come to think of it, this sounds much better than everyone building bridges to nowhere and working for government alphabet agencies. Quick, somebody propose this idea to Obama!

Neil at Debt Advice 4 Free said...

I think that a focus on financial education slightly misses the point. Most people don't buy stuff on credit becasue they don't understand APR, they buy because they have been brainwashed into thinking that having the latest thing will make them and their famil happy.

In this way the current crisis is caused by the pressures of society as much as it is by lack of financial education.


Anonymous said...

How about just teach a personal finance class for all high school kids? That would be my suggestion.

Why start so late? Should be no later than third grade. Once fractions and decimals are learned, practical application of math needs to applied.

Anonymous said...

Sometime being blunt is the only way to get the point across - Robert Shiller is a moron.

Subsidies are ANTITHETICAL to personal finance! Only a person insulated from real life by academia would not see the contradiction.

pjcalafi said...

There should be a mandatory basic financial education course at least when you apply for your 1st credit card.

Sidney said...

401(k) accounts got hammered in part because participants were poorly trained, in part because they were pressured by society, but mostly because the central bank pursued dangerous monetary policies. The credit expansions leading to malinvestment leading to asset bubbles leading to busts start with the Fed. So, if we are going to have more PhD's in Economics, let's make them study Austrian economics rather than Keynesian cleverness.

Anonymous said...

I agree, basic financial education is a start.

But when confronted w/ asset bubbles, don't we cross the line from financial education to using one's common sense ?

You can't teach common sense, or tell someone that their greed is overtaking their good sense of judgment.

Anonymous said...

Excellent post.

Anonymous said...

If people were more financially and economically savvy, they would know that less govn't is better for them. Therefore, they are not going to be taught Jack Squeeze by the govn't.

staghounds said...

We tell our government we want free money.

Our government creates and gives us free money.

Free money loses its value.

We demand free money.

Why shouldn't this go on forever? The British have been doing it for a century now, no end in sight.

The only losers are people who already have some money and want its value to stay high. There aren't many of them, and getting fewer all the time.

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