Financial literacy matters

“In our time, the curse is monetary illiteracy, just as inability to read plain print was the curse of earlier centuries.”
Ezra Pound

Inflation is back. Interest rates are raising worldwide. Political instability is destabilizing the global economy, causing currencies to depreciate dramatically and eroding households’ savings at unprecedented rates in modern history. In this complex scenario, there is no substitution for knowledge. Empirical research has clearly established that households’ ability to accumulate and protect wealth over time is significantly lower for those whose members are less financially literate.[1] This difference becomes even more pronounced during difficult times, exacerbating income inequality and leaving many behind. For all these reasons, it is crucial to understand that this is the time when sound financial decisions matter the most. But what does “sound decision” even mean?

Finance is not the science of making money. It’s the art of pursuing happiness.

The most common misconception when it comes to managing savings is that financial management is a synonym for maximizing returns. This wide-spread believe leads less financially literate households to gamble their wealth, resulting often in negative outcomes. Treating financial markets as if they were a casino is indeed the perfect receipt for a disaster. Rather, it is important to understand that financial markets exist to allow individuals to pursue their goals by allowing them to manage their savings over time. This simple realization leads to a crucial consideration – which is often overlooked by naïve investors: why are you doing it? Why are you saving money? Why are you investing?

Whether you are trying to buy a house or a new car, to start a business, or to accumulate wealth to retire at the age of 50, you need to have clarity about your own objectives. The most important initial step is indeed to set an investment horizon – or, in plain English, a date at which you plan to liquidate your investments and use your money to achieve your goal. You will never make good financial decisions if you don’t even know why you are investing in the first place!

Everything else follows the “Why” and “When”.

Once you have a proper answer to these two questions, setting up your portfolio is easy. If you know the “Why” you will indeed have a good idea about the amount of money you’ll need to achieve your goal. Similarly, knowing the “When” will provide you with a well-defined exit date. For instance, if you want to retire at the age of 50, a rule of thumb is to accumulate about 26x your yearly income. Now, you just need to connect the dots by shopping for the appropriate financial instruments (bonds, stocks, deposits). Easy, isn’t it? Well, no. Which instruments? What does appropriate even mean?

~Novel Serialisation: Heavens Fire~

Hi, I am your RoboAdvisor.

We started our conversation by stating that there is no substitute for knowledge. However, there is a good news for small investors. Knowledge is becoming cheaper. Thanks to the use of machine learning and deep learning algorithms, “robo-advisors” are rapidly substituting expensive asset managers and financial advisors, providing effective asset allocation services at a very reasonable cost. Wealthfront, Betterment, Acorns, Sofi Automated Investing, among others, offer easy-to-use services allowing investors to just state their objectives and enjoy the run, ultimately reducing the gap with sophisticated investors. Problem solved?

How do I shop for a robot advisor?!

You would never buy a product that you don’t fully understand. And you are right. While big data analytics and machine learning are helping democratizing knowledge, access to these tools still require an effort from the consumer behalf. Hidden fees, bad algorithm, and even outright frauds are all around us. Awareness and attention are crucial, but there will never be a perfect substitute for studying, reading, and understanding. Recent analyses show indeed that studying home economics in school results in significantly higher level of wealth accumulation over an individual’s life, providing strong support for introducing and expanding home economics education, especially given the rising level of credit card debt accumulated worldwide.[2] Private debt is a dangerous weapon. Don’t use it if you don’t know how to manage it!

A final word of caution: set goals, not dreams!

The first pillar of finance is that the expected returns increase in risk. If you are asking your portfolio to generate very high returns to achieve your goal, do not forget that this possibility will come at a very high cost. The S&P 500 index has returned a historic annualized average return of about 6% since 2000. Be reasonable in setting your goals!

Are you ready to go back to the basis? Ask yourself these two simple questions – Why and When -, and your financial wealth will materially improve over time. And remember, Wall Street is not in Las Vegas.

By Dr Gabriele Lattanzio

Dr Gabriele Lattanzio is an Assistant Professor at the Nazarbayev University, Graduate School of Business in Kazakhstan. His research interests include empirical corporate finance and financial economics.

[1] Bianchi, M., 2018. Financial Literacy and Portfolio Dynamics. Journal of Finance 73 (2), pp. 831-859

[2] Behrman, J.R., Mitchell, O.S., Soo, C.K., Bravo, D., 2012. American Economic Review 102 (3), pp. 300-3004