Thursday, June 11, 2015

Financial Literacy

April was proclaimed as National Financial Literacy Month in the United States.  During that month, a top 5 financial magazine ran an article by a self-described "financial educator" who tried to argue that the real problem was not actually financial literacy, but rather "financial unawareness".  The article stated that most personal finance issues involve only overextension, self-deception, and lack of motivation, not lack of knowledge.  In an attempt to downplay the need for basic financial knowledge, the author made the following statement:

"If you can write a check, then you have all the skills necessary to balance a checkbook."

Wow.  If this is how certain financial educators view the world, then clearly we are in much worse shape than I ever imagined.

Writing a check is a trivial exercise.  You only need to write the date and amount, copy the payee's name, and sign your name.  Almost every 10-year-old can easily write a check.

On the other hand, balancing a checking account requires additional knowledge and skills that are not usually taught in school (or at home).  This is why the average 16-year-old does not know how to properly balance a checkbook, and many adults don't know how to do that either.

While balancing a checkbook isn't rocket science, there are a number of things to understand beyond how to simply write a check.  At a minimum, a checking account holder should understand that:
  • Banks often charge maintenance fees, which are automatically deducted at monthly intervals.
  • Banks typically place a hold on deposits. You cannot withdraw that money immediately.
  • Checks do not clear immediately.
  • Your bank statement or ATM receipt indicates your cleared balance, not your working balance.
  • You alone are responsible for keeping track of your working balance!
  • Signing a check is like signing a binding contract.
  • It is illegal to knowingly write checks with insufficient money to cover them.
  • Inadvertent overdrafts typically incur interest and/or fees, and overdraft terms vary widely.
  • Personal checks are not guaranteed funds.
If you doubt whether there is really a lack of public understanding of these issues, I would suggest standing in a teller line at the bank.  Most of the people are there to complain about their balance because they didn't understand one of the issues listed above.

Apparently, we first need to start educating some of the educators.  I'd say we've got our work cut out for us.

Thursday, June 4, 2015

Finances and Control

Yeah, you'll never be whole
Yeah, you'll never be whole
Until you lose control
- Foster the People, A Beginner's Guide to Destroying the Moon

Throughout the years, this blog has often stressed the importance of financial automation.  Having just been through a particularly hectic and chaotic time of my life, I have come to a fresh appreciation for it.

Automation is not a novel idea.  Most financial bloggers have written about it at some point.  But there is still a sizable minority that strongly resist any serious automation of their finances. The most common reservation is that people say they don't want to give up control. Hence, such people want to examine their bills and then authorize payment, rather than having money automatically deducted from their account.  Similarly, such people want to examine market conditions each time before committing investment funds.

Although I have written before about the mechanics of this topic, this time I want to discuss the underlying rationale, for automation is only the veneer of the deeper issue of establishing default behavior in your life.

Most readers of this blog live in "opt-in" societies, where the default behavior for most aspects of our lives is to take no action.  This means you must either constantly make active choices or you must establish your own alternative default mechanisms.  The advantage of such a paradigm is that it produces a lot of individual freedom: people are free to make different choices every day about many things, and if they desire, they can also establish defaults for themselves.  The disadvantages, of course, are that (a) many people make poor choices, either because they are ill-informed or because they lack skill in making decisions, and that (b) if people don't make a decision, the "no-action" default is unlikely to be suitable in many cases.

We all like to be in control of our finances, and the process of actively making choices about our money makes us feel that we are in control.  Ironically, however, an overreliance on active choice may result in an illusion of control.  This may happen in various ways.  We may simply not make the required choices in a timely manner (or at all) when we are busy or ill.  We may also make short-sighted decisions based on fear or anxiety, even though we may know deep down that such actions are illogical.

This lack of constructive default behavior is exactly how many people wind up missing the boat financially.  By attempting to always preserve an active choice in repeated matters, we set ourselves up to potentially make a series of bad choices, often for prolonged periods of time.  In some cases, we may even repeatedly make the opposite decision than we would have made had we only been allowed to make the decision once.  You may think that sounds odd, but I'm sure we all know people who conceptually agree that investments must generally be in the market over the course of their life, yet month after month they fear that prices are too high and take no action.  Eventually, they have been out of the market for 15 years and there is no way to do things over again.

But fortunately, if we are allowed to choose, then we are allowed to construct our own default behavior and automate that default.  Extra care must be given in choosing the default, and extra time must be given to putting the mechanism in place.  This usually leads to the opposite of the negative scenario mentioned earlier.  We now feel less control as transactions automatically happen, but in reality, we are likely to be far more in control than someone without positive default behavior.

If you have never thought about these sorts of things before, you may want to read about them in more depth than you will find here. These ideas are addressed tangentially in Gladwell's Blink and more directly in Thaler's Nudge.