By: Annamaria Lusardi and Olivia S. Mitchell
Annamaria Lusardi is the Denit Trust Chair of Economics and Accountancy at the George Washington School of Business (GWSB) and academic director of GWSB’s Global Financial Literacy Excellence Center. Olivia S. Mitchell is the International Foundation of Employee Benefits Professor of insurance/risk management as well as business economics/public policy, and Director of the Pension Research Council, at the Wharton School of the University of Pennsylvania. @OS_Mitchell
Brokers, financial advice providers, and many others need to test peoples’ ability to manage their money. Nevertheless, there are some who debate such tests arguing that they aren’t useful for predicting behavior. But our work has confirmed that there actually IS a short and very effective diagnostic financial literacy test that can be used to measure financial know-how and predict behavior.
Our three questions, now known as the “Big Three,” measure how much people know about the key concepts driving smart financial decision-making. Test yourself now! (correct answers are provided at the end)
1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?
More than $102
Less than $102
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?
More than today
Exactly the same
Less than today
3. Is this statement True or False? Buying a single company’s stock usually provides a safer return than a stock mutual fund.
These questions are critically important for three reasons. First: the Big Three do a good job measuring whether people know basic financial concepts critical in managing everyday finances like paying off credit cards, managing a checking account or shopping around for good financial terms. Of course more sophistication would be useful in order to handle higher-order financial decisionmaking! But not understanding a simple interest calculation means someone is likely to make significant financial mistakes, and even be potentially subject to financial fraud.
Second, the Big Three can cleanly differentiate different types of individuals and investors. For instance, we have shown that, around the world, these questions detect sharp differences in financial literacy between men and women. When asked to respond to the Big Three, many more women than men say that they don’t know how to answer the questions. From a practical point of view, that is useful to know: for instance, educators, policymakers, and financial institutions are now seeking ways to build financial knowledge levels in the general population.
Third, performing well on the Big Three is strongly predictive of savvy financial behavior. For instance, people who score well are much more likely to engage in retirement planning and saving. And this is true not only in the United States, but also in many other countries which have included our questions in their national surveys. We also find that financially more sophisticated people invest smarter in their retirement plans. And they are also good at debt management, another important contributor to financial wellbeing.
Looking ahead, the Big Three have now been added to the Federal Reserve Bank’s Survey of Consumer Finances, an invaluable survey used to evaluate family finances. In particular, this will make it possible to link financial literacy and debt as well as wealth. This is where our research will take us next. When we considered a life cycle model of wealth accumulation, we found that 30-40 percent of retirement wealth inequality can be accounted for by financial knowledge. In other words, financial literacy matters!
We are delighted that the Big Three have now been accepted globally, as a measure of financial comprehension and to predict savvy financial outcomes. And to further this objective, we propose that every high school should now require at least a minimum competency in financial education for graduation. How else can we protect the next generation from the financial crises of the past?
Correct answers: More than 102; Less than today; False. The online surveys also permit respondents to reply that they do not know the answer or would prefer not to respond.
This piece was originally posted on December 14, 2017, on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.