Compound Interest? Huh. Investors Flunk Key Financial Literacy Test

Dodd-Frank financial reform mandated a study on what Americans understand about investments. The results weren't pretty.

  • Share
  • Read Later

Everyday investors who buy bank CDs, select money market and mutual funds, allocate assets in a 401(k), and borrow to buy a home or car, know painfully little about the way money works, a new study concludes. Sadly, Americans didn’t just flunk this latest financial literacy test; they got almost nothing right.

The Securities and Exchange Commission ordered the Study Regarding Financial Literacy Among Investors, as required by the Dodd-Frank financial reform laws. The result is a 182-page tome on financial ignorance, which prompted one commentator to opine:

“And now, with the SEC’s study proving in dramatic and depressing fashion what everyone already knew, it’s about time for regulators to step in and force retail investors to close their eTrade accounts, step away from CNBC, put all their money in passive index funds, and go mow the lawn instead.”

(MORE: The Real Reason We’re Suddenly Happier with Our Credit Cards)

The report found that American investors “lack basic financial literacy” and “have a weak grasp of elementary financial concepts.” The Financial Literacy and Education Commission, which participated in the study, concludes that we need education programs in schools, the workplace and community centers that will teach investors about investment risk, fees, fraud, expected returns and how to manage lump-sum payouts.

The most damning passage in the report is this zinger:

“Studies have found that investors do not understand the most elementary financial concepts, such as compound interest and inflation. Studies have also found that many investors do not understand other key financial concepts, such as diversification or the differences between stocks and bonds, and are not fully aware of investment costs and their impact on investment returns. Moreover, based on studies cited in the Library of Congress Report, investors lack critical knowledge about investment fraud.”

That’s a mouthful. Compound interest? Albert Einstein purportedly called it “the most powerful force in the universe.” You’d think that would merit some level of inquiry and understanding, especially among investors whose very goal should be to let assets grow over time.  Inflation? This is why it takes $100 today to buy what you could have got for $42 in 1982. Stocks and bonds are as basic as basic gets. And in the age of Bernie Madoff who doesn’t get that investment fraud happens?

This is mind-boggling stuff, and as the SEC study points out:

 “Low levels of investor literacy have serious implications for the ability of broad segments of the population to retire comfortably, particularly in an age dominated by defined-contribution retirement plans.”

(MORE: The New Shape of Retail)

The whole point of this study was to find out how capable Americans are when it comes to handling their money and to begin to determine what level of help they need to avoid screwing up royally and tripping into another financial meltdown like 2008. If this is the verdict, it’s not in our favor and the case for teaching basic money concepts starting at an early age has never been more self-evident.

0 comments
Sort: Newest | Oldest