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Not So Fast: Maybe Consumers Aren't as Dumb as We Seem

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I’ve never been a fan of standardized tests. The “best” answer depends at least as much on the test taker’s knowledge and understanding of the test creator. Particularly troubling to me were questions that ask for the next letter-number-object in a sequence of two or three. I always found myself spending more time trying to figure out what the tester would think was the right answer than on the right answer itself.

Consequently, I felt some vindication recently, watching the 2008 movie “The Oxford Murders,” staring John Hurt and Elijah Wood. The movie is set in the mathematics department at Oxford University. I’d have to rate the murder mystery as “fair,” but what saved the movie, for me at least, was the revelation that for any number sequence (and by extension, any sequence), you can find a rationale for virtually any number or object as the next item in the sequence.

Don’t believe it? Here’s an example. Consider the sequence 1, 2, 3 … . What’s the next number? Four, right? Well, not so fast. Our more mathematically inclined readers will recognize five as the next number in the famous Fibonacci sequence, in which subsequent numbers are the sum of the two preceding numbers: 1+2=3, 2+3=5, etc. This sequence describes the structure of many of the building blocks of life (and is considered by the Freemasons as the “Golden Mean,” but I digress).

In the binary number system, or “base 2” (using only 1s and 0s, as opposed to our usual base “10” system), the next number in the 1, 2, 3 sequence might be 10 (in base 4). I think you get the point: The “right” answer to almost any question often depends more on the understanding of the tester than the tested.

I was reminded of all this the other day, as I was reading about the new Global Financial Literacy Survey by Standard & Poor’s Ratings Services, conducted by Gallup and World Bank and released in November. The results paint a dismal picture of financial literacy around the world and here in the U.S. Yet after taking their five-question literacy test, I’m left wondering whether the results say more about the financial literacy of the people who created the test, rather than the people who took it.

I won’t bore you will all the global results, other than the perhaps not surprising finding that “67% of adults worldwide are not financially literate.” But the survey’s data on U.S. adults aren’t encouraging either:

  • “Even though U.S. credit card use and student debt is among the highest in the world, interest is the least understood topic in the U.S., with 40% of adults answering the interest topic incorrectly.”

  • “U.S. adults with a tertiary [college or higher] education rank 28% higher in financial literacy than U.S. adults with just a secondary education. No other G7 country has such a pronounced gap.”

  • “In the U.S., 60% of adults have a credit card, [but] only 57% of them correctly answer the interest question.”

  • “Relatively poor adults in the U.S. have weaker skills than their counterparts in certain rich countries: 47% of U.S. adults living in poorer households are financially literate. Countries that are doing much better include Denmark (65%), Sweden (64%), the U.K. (63%) and Canada (61%).

  • “In the U.S., 32% of adults use housing finance — such as a mortgage — from a bank or other financial institution, but only 62% correctly answered the interest question.”

  • There’s a significant gender gap in the U.S.: “62% of men in the U.S. are financially literate, compared to 52% of women. This 10-percentage-point gender gap is twice as large as the global gender gap.”

Not a very pretty picture in a society where each of us is (at least in theory) responsible for our own financial well-being. Yet as a professional skeptic, I have to wonder just how S&P et al., arrived at these dire conclusions.

I took their financial literacy test myself and got all five questions right, but I have to admit that I cheated: That is, I chose the answers that I concluded the testers were looking for, rather than what I thought was actually the best answer. What follows is each question, with the list of possible answers to choose from. You’ll find S&P’s answer, along with my thoughts about the best answer, following each question.

1. Suppose you have some money. Is it safer to put your money into:

a. One business or investment

b. Multiple businesses or investments

S&P’s answer is that buying multiple businesses or investments is safer than investing in only one business or investment. While this is the idea of portfolio diversification, is it always safer in every circumstance?

It’s generally safer to invest in all S&P 500 companies rather than just one of them, but is investing in all three of your brother-in-law’s tech startups really safer than investing in Apple?

My best answer: “Don’t know,” without more info about the investments themselves.

2. Suppose that over the next 10 years the prices of the things you buy double. If your income also doubles, will you be able to buy:

a. Less than you can buy today

b. The same as you can buy today

c. More than you can buy today

S&P’s answer is that you can buy the same as you can buy today, but is this really true under all circumstances? Let’s say I make $400,000 a year, and my living expenses are $100,000 a year. I could currently buy more, but I don’t. If prices and my income double, I can still buy more (but probably won’t). On the other hand, if I make $100,000 a year but spend $200,000, and income and prices double, I probably won’t be able to spend as much due to growing debt service.

Again, without more information, my best answer for this question is “don’t know.”

3. Suppose you need to borrow $100. Which is the lower amount to pay back?

a. $105

b. $100 plus 3%

S&P’s answer is that it’s cheaper to pay back a loan of $100 with 3% interest than a flat $105. That’s certainly true — if you pay off the loan in one year. However, if the 3% is annual compounding interest and you take two years or more to pay it off, the $105 fixed payment is looking better.

My best answer: “It depends.”

4. Suppose you put money in the bank for two years and the bank agrees to add 15% per year to your account. Will the bank add:

a. More money to your account the second year than it did the first year

b. The same amount of money both years

S&P’s correct answer is that the bank will add more money to your account the second year than it did the first year. And this is certainly true, if the bank agreed to pay “compound” interest, and if “put money in the bank for two years” means you put in a lump sum and left it there (as with a CD). But what if it means you put in, say, $100 a month for two years? Or if you took some out? Or if the bank agreed to add “simple” interest to your account? The amount would be the same or even less.

My best answer: At best, poor wording.

5. Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account?

a. More than $150

b. Exactly $150

c. Less than $150

S&P’s answer: more than 150 dollars. Again, the final amount would depend on whether the bank or other borrower agreed to pay simple or compound interest on the original deposit.

My answer: “don’t know.”

When I told her my concerns about the survey questions, S&P/McGraw-Hill spokesperson Anna Lusardi responded: “There are a lot of difficulties when formulating questions to be used in different cultures around the world. We wanted to focus on universal financial concepts, and we didn’t want the questions to be too long. After one year of asking questions and doing a lot of focus groups, we concluded that those five questions on four of the most basic concepts gave us the most repeatable results.”

What’s the takeaway here? As I said, I knew what answers S&P was looking for in its survey, and as a financial professional, I’ll bet you did, too. But would a normal person who doesn’t deal with finance for a living know the right answers? Judging by the results of the survey, I’d guess not. That to my mind raises the question of whether this survey is a better indicator of financial literacy of the participants or of the people who created it.

— Read “The Dumbing Down of the Financial Services Industry’s Future” on ThinkAdvisor.