The Sunday Times 25 June 2017
This column, and others like it, assume a level of financial knowledge that may be unwarranted. A recent Organisation for Economic Cooperation and Development (OECD) financial literacy survey asked seven questions, three of which are outlined below:
1. High inflation means that the cost of living is increasing rapidly, true or false?
2. It is usually possible to reduce investing risks by buying a wide range of stocks and shares, true or false?
3. You put €100 in a savings account earning 2 per cent annually. How much would there be at the end of the year – €100, €102, or €120?
(Answers: true, true, €102.)
You may consider these to be basic questions, but of the 51,650 adults surveyed just 56% passed what was considered to be the minimum target score of at least five out of the seven questions.
78 per cent correctly answered the first question; one in three didn’t realise one could reduce risk via diversification. And astonishingly, 42 per cent of people were unable to calculate what 2% interest for a year delivered on a €100 deposit.
30 countries were included in the survey; Ireland wasn’t one of them, but the UK was, scoring below the overall average.
I have mixed feelings towards the survey results.
In terms of general financial knowledge, I’m concerned. Findings from the US confirm that low levels of financial literacy are associated with the usage of high-cost products such as pawnbrokers or pay-day lending. Surveys show those with the lowest levels of financial literacy are overwhelmingly more likely to use these kinds of products even when cheaper products are available to them.
In addition, failure to plan for retirement and lack of participation in the stock market are both linked to ignorance of basic financial concepts. Those who are financially literate tend to hold a more balanced portfolio, tend to be more aware of issues around the need for proper pension planning, and tend to be more financially resilient.
So there seems to be a strong argument for the State to ensure its citizens are as financially literate as possible. Knowledge is power with respect to general financial concepts and I’m in strong support of this.
I take a more sanguine view in relation to the OECD survey as it relates to the more complex area of investing.
Investment markets are one of those intricate areas where a little bit of knowledge can be more dangerous than no knowledge at all. I’m fairly certain I’ve strayed outside my circle of competence in carpentry – there are few dubious wooden constructs in the Connolly household testament to this. Investing, however, is a little more serious.
The great menace in investment markets according to renowned psychologist at Cornell University David Dunning “is not ignorance, but illusion of knowledge”. Self-perceived expertise causes people to think they know more than they really do leading to uninformed financial decisions with potentially devastating consequences.
My own assessment of knowledge levels in the general market would be that they are quite poor. Expectations for return are generally way off, the probability assigned to drawdowns considerably misjudged and the compounding effect of returns significantly underestimated.
Becoming better calibrated in terms of return expectation is not easy. Investing is not like a physics experiment; we must learn as we go along and sometimes make costly mistakes.
The advice trotted out to would-be investors by advisers is usually some variant of the glib ‘take a long term view’. The long term is not where life is lived. The long term is made up of a series of short terms. Plenty of investors commit to investing for a 10-year period, but behave as though this is made up of twenty 6-month periods. To get to the long term, it is important that you survive all of these short-term periods along the way. That advice is easy to articulate but difficult to follow because of psychological constraints.
It’s quite clear that deposit interest rates at close to zero has propelled a sense of urgency amongst investors. In addition, investment product providers seem to be embedding products with increasing complexity making the job of deciphering value ever more difficult.
The lesson from this missive should be to seek advice, even if you think (or possibly especially if you think) you don’t need it.
The lessons from the three opening questions are simple: be mindful of the impact of inflation on your returns, reduce risk by diversifying and watch the proceeds snowball over time due to the magic of compound interest. Simple? Yes. Easy? Not in my experience!
Warning: Past performance is not a reliable guide to future performance.
Gary Connolly is Managing Director of iCubed, promoting better investment outcomes through a collaborative approach to investing. He can be contacted at firstname.lastname@example.org or on twitter @gconno1.