Financial IQ

Newsweek had a pair of articles in the last issue that made me think. The first one, "Clues for the Clueless: The mortgage crisis may create momentum for improving our financial literacy. It's about time," is what I'm talking about today. The premise in the article is that the personal financial environment we live in has gotten markedly more complex since 1980 and we're not doing a good job of retraining. The advent of 401(k) plans over defined-benefit pension plans, mortgages other than 30-year fixed, and home equity lines of credit mean what our parents taught us about money isn't always true or accurate, if they even talked to us about it at all.

As it happens, most of what I learned about money came from two sources. The school of hard knocks, and my father in law. I learned about stocks in grade school. Compound interest is a standard math exercise once you get to a certain level (which few do, but I did). Mutual funds? No where to be found. Adjustable-rate-mortgages? Likewise. Debt restructuring? Nada. The prime lesson I got from my parents was a simple one, "Don't go into debt."

Unfortunately, a prime part of the American Experience is managing debt. Car payments for the car you put 10% down on, house payments for the house you put 2% down on, and credit-card payments for the cards you statistically aren't fully paying off every month. The one exception to the 'no debt' rule was a mortgage, since NO ONE pays cash for a house, and I think banks are required to report to the IRS whenever anyone does just that.

A second article, High Finance Laid Low, goes into a bit more depth about how things have changed:

Consider mortgages. In 1980, they came in one flavor: 30-year fixed-rate loans. Because fees and closing costs were so high, it was hard to refinance into a cheaper loan even if interest rates fell. The rule of thumb was that rates had to drop 2 percentage points before refinancing made sense.

When I covered compound interest in school, the 3o-year fixed was one of the examples. When we bought our first house in 1997, there were a few more options, such as the 15-year fixed, and 3 and 5 year adjustable-rate-mortgages. But still, I was told the 2% rule by many people. That mortgage was 7.25% if I'm remembering right.

Now we have a lot more options such as 40-year fixed rates mortgages, interest-only loans (eeeeeviiiiill), and many more types of ARMs. Part of the reason we're in the housing crisis is in part due to a lack of complete understanding, on the part of the consumers, of the risks involved in an adjustable rate mortgage. This is due in part to the fact that these instruments didn't exist even 10 years ago, and it hasn't entered our ancestral memory yet.

More fun figures:

Personal investment choices have mushroomed. In 1980, households had half their financial assets in bank deposits and savings accounts; only 34 percent were in stocks and a meager 2 percent in mutual funds. Since then, Americans have diversified: in 2006, 25 percent of household assets were in mutual funds, 28 percent in stocks and 28 percent in bank deposits and savings accounts (the rest were scattered across bounds and money-market funds).

The demise of the defined-benefit pension plan in favor of defined-contribution 401(k) style plans has forced an entire generation (or two) into the stock market. The boomers had this transition happen mid-career, depending on the sector they work in. Generation X, like me, has had 401(k) plans from the get go or were one of the last to get the defined-benefit plans, but had zero preparation for 401(k)'s in our schooling. Generation Y (also knows as the Millennials) has had 401(k) as the standard option since they entered the workplace, but they at least get the benefit of the collective folk wisdom of the rest of us; I have no idea if these concepts are covered in school these days.

As I mentioned before, I had a class unit in 5th or 6th grade where we were given $10,000 fantasy dollars and were to play the market. The prime lesson here is that stocks go up and stocks go down. If you choose good, you can make money. If you don't choose good, you lose money. It did not teach us about SEC filings, 10-Q reports, or any way to analyze whether or not a company is on sound financial footing.

Because of this lack of formal preparation, we are prone to folk wisdom and herd mentality. We do not teach risk management in school, and instead leave it to intuitive processes. This has some problems, as described in the, "Clues for the Clueless" article:

Finally, when it comes to investing, behavioral economists put part of the blame on "loss aversion." That describes how the average person suffers more pain when losing $10 than pleasure from gaining the same amount; the phenomenon explains people's unwillingness to take risks.

A 24 year old just getting into the market by way of their employer's 403(b) plan (a 401(k) plan for non-profits) may chose a bunch of 'balanced' or bond-funds simply because they want the steady income and don't want to be bothered by losses. Even though they're 40+ years from retirement, and are in the single best position to reap the rewards of 'growth' funds. When the stock market started well and truly tanking this year, I had friends who made a real effort to NOT LOOK at their portfolios; specifically because they knew that if they saw how much they'd lost, they'd be tempted to Do Something about that. Intuitive investors sell low and buy high.

As I alluded to above, part of our problem is that debt has become such a major proportion of our financial lives. As the housing crisis has shown, a vast majority of the average American's net worth is non-liquid real-estate, or non-liquid retirement funds. Therefore, credit becomes a major player. When I buy a car, I do so on the promise of the wages I'll be earning for the next 3/4/5 years. College students routinely come out of college with mortgage-sized debt loads, and it may be decades before their net-worth is positive.

In my specific case, "don't go into debt," has actually worked out. Due to financial planning, a shrewd choice of college, and getting through college on time, I managed to get through without any student debt. The first loan I ever signed up for was my mortgage, which we managed to put 10% down on, and managed to drop PMI 3 years after inception. The first car we bought by way of a loan was a new car, and we still managed to put about 50% down. Having been scared about credit cards by my parents, I didn't get into trouble there; a lesson that was reinforced several times watching friends dig themselves out of exactly that kind of debt-hole. When we get windfalls, we don't immediately blow it all on buying stuff. We have several long term savings goals that we're saving for, and document the contributions.

We are not the average US saver.

Were it not for my father-in-law, chances are good that the financial windfalls we received over the years would be in passbook savings earning a whopping 1.75%. That is very, very safe (thank you FDIC) but not very wise for the bottom line in the long term. My first job was in the public sector, and had a defined-benefit plan (and still do, last I looked), so I didn't have to look at the stock market like my .COM friends were having to do. That plan earned a guaranteed 5% yearly rate, which was kind of nice to know when the memories of the 1991-93 recession were still fresh.

The first time I had to look at the stock market was when I started my new job, in 2003. This job has a defined-contribution plan as the only retirement option. By this point I already knew quite a bit about mutual funds thanks to my father-in-law, so it wasn't the steep learning curve it would have been. Seeing as we were just coming out of the .com bubble-correction in 2003, I probably would have ended up entirely in 'income' stocks rather than where I did.

I know I would have been better served knowing more about how money works. Mutual funds existed in the 1980's, and even 'no load' funds existed. The plethora of mortgage options didn't exist, but more abstract examples of various debt instruments could have been used to illustrate how money works in our economy. "Don't go into debt," served me relatively well until I built up enough financial IQ on my own to be a lot more sophisticated in how my savings works for me.