Financial Literacy Not a Band-Aid to Change All Factors for Smart Money Management

The Centre for Corporate Law and Securities Regulation in conjunction with The University of Melbourne released a Research Report in March 2011 about Financial Literacy and “What Causes Suboptimal Financial Behaviour? An Exploration of Financial, Social Influences and Behavioural Economics”. This following article will showcase their report and findings. All quotes and data used are from their original report.

The 243 report consisted of five parts represented by corresponding letters.

Part A highlighted the importance of financial literacy and the benefits for consumers, communities and economies when people are financially literate.

Part B explains the meaning of financial literacy. In this study they conducted surveys worldwide to show “key competencies and proficiencies” of literate consumers.

Part C shows flaws in decision making with financial products from consumers.

Part D looks further into social, psychological and cognitive causes of “optimal and irrational consumer behaviour”. These social influences include: wealth, income, capital, psychological biases, behavioral economics and nerureconomics. The flaws showcased in Part C can be linked to internal and external causes.

Part E lists the surveys how the financial literacy was measured for this study and explains common findings.

This study does an excellent job of showing why financial literacy alone is not a band aid to change everything, there are a lot of internal and external factors that influence consumer spending and financial decisions.

Financial literacy helps develop sound outlooks concerning money and cause consumers to behave in particular ways. Consumers with a sound understanding and practice of financial literacy often save more money for retirement and unforeseen events and emergencies that may happen in life.

An ANZ Survey of Adult Financial Literacy in Australia identifies three types of savers: rainy day – who save regularly, instrumental savers – who have a purpose and non-savers.

Figure 1: Financial Literacy and Financial Product Ownership - Difference between the lowest 20% of financial literacy scores and the top 20% of financial literacy scores

Financial literacy results in financial efficiency. This refers to the use of financial products and investing without waste and unnecessary cost. Financial literacy therefore gives consumers the ability to live more efficiently, without unnecessary cost and waste.

Financial efficiency is directly connected to debt literacy which consists of knowledge of debt and how to manage and avoid debt. An expert comments, “debt illiteracy can be linked to a number of high cost financial experiences, such as borrowing on credit, using pay day lending or pawn shops. Debt literacy results in selecting products which are needed, while avoiding unnecessary products which increase costs. Understanding where to get help is the first step in remedying debt, and therefore knowledge of this process is important in preventing, mitigating and repaying debt”.

Figure 2: The Variables That Influence Financial Behaviour

The most important influence on financial behavior is knowledge. Psychology, life experiences and hardship are significant in financial literacy, however having knowledge tops all other factors according to a study by Courchane and Zorn. If knowledge is such a determining factor of financial literacy than financial education is necessary to improve behaviors by consumers.

“Financially literate consumers, when compared to financially illeterate consumers tend to:

  • have greater lifetime utility and enjoyment, by having more disposable income;
  • have more savings;
  • save more for retirement;
  • actively manage debt;
  • borrow prudently;
  • be more realistic about their financial goals;
  • be less inclined to overestimate their abilities;
  • be more active in financial markets;
  • be more financially confident;
  • choose with more accuracy financial products that are suitable for their needs;
  • understand consumer rights;
  • have a better understanding of financial products and therefore have greater bargaining power with financial institutions;
  • and plan their finances, budget and know how to be financially efficient.”

Financially literate consumers benefit the financial system and economy because:

  • a better informed consumer demands better quality and better value products, creating more competition, innovation and quality products. This creates market discipline;
  • financially literate consumers are more likely to have sufficient insurance coverage, reducing the burden on the economy for losses and reduced business activity;
  • saving more for retirement moves the burden away from the state, and prepares consumers for self funding retirement; and
  • consumers will be better able to prepare for cyclical changes in the market, and react accordingly.”
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Two main benefits of financially literate consumers provide to the community:

  • ”financial inclusion, because people know how to access financial products and
    services that are appropriate for their needs; and
  • a population that can better understand government financial policies.”

The study defined financial literacy at it’s most basic level as the understanding and knowledge of financial concepts. By understanding these concepts one can make “informed, confident and effective” financial decisions.

A financial literate person should be well versed in the following competencies:

  • Money basics, including numeracy and money management skills;
  • Budgeting, including the ability to keep track of expenses and income;
  • Saving and planning;
  • Borrowing and debt literacy, including knowledge of different types of loans (such as secured and unsecured personal loans) and mortgages (such as fixed and variable), as well as positive and negative gearing. Debt literacy concerns the required understanding to mitigate debt and repay loans.
  • Understanding financial products, including the ability to determine whether independent advice has been or will be given, the ability to decide between financial advisors not just financial products, understanding product features and investment considerations such as risk, return, interest rates, compound interest, simple interest, inflation, company features etc, the ability to compare products and investments by shopping around, and understanding concepts such as diversification and risk minimization. Financial products include insurance; and
  • Recourse and self help. This includes whether consumers have the ability to protect themselves by understanding dispute resolution procedures, taking redress against a financial institution, and being able, where possible, to identify and take action against fraudulent schemes. The ability to understand financial and legal information is also important.

A shocking part of the study showed in regards to debt and borrowing a large number of those surveys did not understand unsecured vs secured personal loans or fixed vs variable interest rates on mortgages. “A key competency of a financially literate consumer is the ability to understand debt, and the processes involved to avoid it, reduce it, repay it and maintain a good credit rating.”

Debt literacy is connected to over-indebtedness and an inability to reduce debt levels. Those who find themselves in debt or who have found themselves in debt should take their knowledge of their past and use it towards their future literacy of finances and debt.

I found it particularly shocking that from the ANZ Survey that 50% of the bottom 20% did not understand that the person responsible for a credit card if the primary credit card holder or that being late in payment would lower their credit score.

The key competencies are:

  1. money basics, including numeracy and money management skills;
  2. budgeting and living within means;
  3. saving and planning;
  4. borrowing and debt literacy;
  5. choosing and understanding financial products; and
  6. understanding consumer recourse and self help.

Many consumers fall behind with choosing financial products including investments and financial information.

Figure 3: Risk and Return Meter
Figure 4: The Spectrum of Risk for Particular Financial Products

This study shows not only the importance of financial literacy but also a key component of that being smart comparison shopping for financial products. Many flaws were found in consumers with decision making pertaining to financial products. For example:

  • not consider key features of financial products, such as risk and return;
  • not read the terms and conditions of products;
  • not compare financial products and “shop around”;
  • not assess the appropriateness of already owned products, and revise their ownership of these products as circumstances change;
  • purchase unnecessary products;
  • not consider fees and charges;
  • ignore investment objectives;
  • be “short sighted”;
  • “compartmentalize” money;
  • not seek or receive independent financial advice;
  • not understand financial advice;
  • rely too heavily on non-professional sources of information; and
  • not gather or review information relevant to financial products.”

Suboptimal financial behaviour has been assumed to be caused by limited understanding and knowledge in rational beings. However, research in behavioural economics and psychology shows that people do not always behave rationally. Suboptimal consumer decisions arise from this tendency in people to act irrationally. Suboptimal consumer decisions also result from social factors, such that rational and irrational judgments result from contextual influences in a person’s life.

Multiple studies have been able to find a connection between financial literacy and particular behavior. Consumers are often thought of as rational beings, ones who will shop around for the best deal and comparison shop. By psychological standards rational decisions are “‘in the best interests of the agent who makes them, relative to the information available to the agent at the time of acting”.

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“The suboptimal consumer behaviour identified in the financial literacy surveys and the literature include:

  • Minimal saving, particular for the long term;
  • Not budgeting;
  • Not planning ahead, specifically for retirement;
  • Incurring unnecessary debt;
  • Incurring unnecessary fees, such as credit card fees for late repayments;
  • Inertia in financial markets;
  • Choosing inappropriate financial products;
  • Lack of confidence;
  • Not considering the key features of financial products; Not reading the terms and conditions of products;
  • Not undertaking comparison shopping;
  • Not assessing the appropriateness of already owned products;
  • Not considering fees and charges;
  • Ignoring investment objectives;
  • Short-sightedness;
  • “Compartmentalization” of money;
  • Not receiving or seeking independent advice;
  • Not seeking better instructions or advice when information is not understood;
  • Relying too heavily on non-professional sources of information;
  • Not gathering or reviewing information;
  • Not buying insurance when needed.”
Figure 5: Possible Causes of Financial Behaviour

There are many social factors that influence one’s financial behavior. To see CCLSR’s full table of flaws linked to behavior and social/psychological causes click the picture to the left or follow this link.

“Social factors can diminish or enhance the ability to acquire proficiency (either cognitive, acquired intellect or knowledge); and therefore understand financial terms and concepts; and gain access to financial opportunities.”

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Social Factors that influence consumer behavior are listed below:

  • Socio-demographics;
  • Complex markets and financial products; and
  • Culture

Employment level, employment status, earning capacity and household and personal wealth are key socio-demographics that can influence financial behavior positively or negatively.

“Socio-demographics which score poorly in financial literacy tests include:

  • Women;
  • Young people;
  • People experiencing unemployment;
  • People who are not working such as retirees and students;
  • The elderly;
  • People with low incomes;
  • People from disadvantaged areas;
  • People with no tertiary education;
  • People from families with low financial sophistication and participation;
  • Single parent households;
  • People who are renting and neither own a home outright or are buying a home;
  • Immigrants; and
  • People from social and ethnic minorities including those with less developed English proficiency.

Demographic and socioeconomic groups which tend to score higher on financial literacy tests are:

  • Men;
  • Middle aged people;
  • Professionals;
  • Business owners;
  • Small business and farm owners;
  • Skilled and semiskilled tradespeople;
  • University educated people;
  • Higher income earners
  • People with higher levels of savings; and
  • People with mortgage debt.”

People who are unemployed, students and retired people are at a high risk of not understanding financial literacy and should consider the value of employment to financial literacy and behavior.

In their U.S. study they found that since the recession the percentage of adults keeping close track of their spending has increased from 39% to 43% and 51% of adults say they spend less and save more. Perhaps with the crash of our economy many can now see the importance of financial literacy. It is important to take positive and effective steps to increasing our literacy in finance if we want to thrive as well-off financial beings.

To read the complete study you can do so by clicking here.