Understanding basics of financial literacy is a must

By Chris Farrell

April 29, 2023 at 12:00PM

Student loans. Credit cards. Buy now, pay later. Traditional IRAs, Roth IRAs, and 401(k)s. Fixed-and adjustable-rate mortgages. This list scratches the surface of complex financial decisions and products people navigate as they manage money over a lifetime.

April was financial literacy month, and there's no doubt that understanding the basics of personal finance and risk management matters. People are on their own more than before when managing money. The evidence is overwhelming that many lack basic financial knowledge. For example, starting in 2004 economists Annamaria Lusardi of the George Washington University School of Business and Olivia Mitchell of the Wharton School of the University of Pennsylvania came up with a test for surveys known as the "Big Three."

Question 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? A) More than $102. B) Exactly $102. C) Less than $102. D) Do not know/Refuse to answer.

Question 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? A) More than today. B) Exactly the same. C) Less than today. D) Do not know/Refuse to answer.

Question 3: Please tell me whether this statement is true or false: "Buying a single company's stock usually provides a safer return than a stock mutual fund."

(The answers are 1) More than $102; 2) Less than today; 3) False.

In their recent paper "The Importance of Financial Literacy: Opening a New Field," the scholars note only 43% of respondents answer all three correctly. There are gaps by gender, educational levels, race and ethnicity. The scholars have created longer tests, but the message remains the same.

The problem is real. What approach is best to address the financial literacy shortfall is less certain? For one thing, too much is asked of individuals to manage risks and not enough of institutions to simplify financial choices. Second, while experience is the best teacher, learning money basics in high school and college should better prepare students for future decisions about money. Much is being asked of schools these days, but requiring a familiarity with the basics of personal finance would hold students in good stead when they graduate.

Chris Farrell is economics contributor to the Star Tribune, Minnesota Public Radio and American Public Media's "Marketplace."

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about the writer

Chris Farrell

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