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Business

October 20, 2013

The value of financial literacy

At a time when Americans have been forced to assume greater responsibility for securing their financial futures, they face a complex economic landscape in which they must make important decisions, including those relating to borrowing, spending, saving and investing. Most lack the knowledge and computational skills to do so successfully.

Financial literacy in the United States is alarmingly low even among well-educated and higher-income individuals. These are the conclusions of independent studies conducted by research organizations and academic institutions, including the RAND Corporation and the University of Michigan. The surveys clearly demonstrate that many individuals lack a basic understanding of simple financial concepts, including time value of money, compound interest and asset allocation. Knowledge of more complex topics such as portfolio construction, tax minimization and nominal vs. real rates of return was almost non-existent.

Interestingly and perhaps more worrisome, the evidence suggests that consumers often overestimate how much they know. This bias of individuals to misjudge their knowledge relative to objective assessments can lead to poor credit, budgeting and investment decisions. Conversely, those who offered a more realistic assessment of their level of financial proficiency did a better job of budgeting, saving and investing for the future.

Financial literacy affects the quality of personal financial decisions. The 2008 financial crisis highlighted the difficulties that consumers face navigating a financial system comprised of complex products sold by sophisticated financial institutions and their sales representatives. For many, the consequences of making bad decisions proved to be financially devastating forcing them to make major changes to their retirement plans and lifestyles.

Americans routinely confront a bewildering array of financial decisions, including securing an affordable loan, determining how much and how to save for retirement and selecting the right financial, legal and tax professionals. Financial literacy is closely associated with our preparedness for major life events, especially retirement. Possessing basic economic know-how is a strong predictor of financial planning ability and implementation.

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