Take This 3-Question Test Before You Manage Your Own Portfolio

February 19, 2015

Fifty percent of Americans cannot correctly answer 3 basic financial questions relating to interest rates, inflation, and risk. Can you? If not, you need a financial advisor.

Fifty percent of Americans cannot correctly answer 3 basic financial questions relating to interest rates, inflation, and risk. This group needs a financial advisor.

Recently, a talented woman with a job anyone would envy told me that she preferred a money manager for her modest portfolio rather than handling it herself. The task simply did not interest her.

I thought, “One of the reasons your portfolio is smaller than it would have to be is because you are not interested.” My rationale is that she not only could save investment management fees if she did it herself, but also she knows what she wants better than anyone. To my way of thinking, she could do a better job.

Recent research, however, indicates that is not always the case. Olivia S. Mitchell, executive director of the Pension Research Council, and Annamaria Lusardi, professor at the George Washington School of Business looked at the financial literacy of a broad group of people including US participants as well as others around the world. Their paper is entitled, “The Economic Importance of Financial Literacy: Theory and Evidence,” and is published in the Journal of Economic Literature 2014, 52(1), 5—44.

They asked the three the simple questions below. Can you answer them?

Question 1: “Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 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.” (Answer: more than $102.)

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.” (Answer: less than today.)

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.” (Answer: false.)

Among Americans, on average, only 50% could answer the first 2 questions correctly. For the third enquiry, the figure was even less—33%. Essentially, these results indicate financial illiteracy.

The good news is that US citizens with a higher level of education did better. Sixty four percent with a post-graduate degree answered all three questions correctly. This contrasts to 44% of those with a college degree, and only 13% of those without a high school diploma.

To determine if there would be similar outcomes for the rest of the developed world, citizens in Germany, the Netherlands, Switzerland, Sweden, Japan, Italy, France, Australia, and New Zealand were polled. The results were comparable to those in the U.S.

A subset of the study showed that women, on average, are less financially literate than men. For the US, 38% of men compared to 23% of women were able to answer all 3 questions. In Germany, the numbers were 60 and 47% respectively. For the Netherlands, 55 and 35% and for Switzerland 62 and 39%. Note that the figures for both sexes in the US were, on average, considerably lower than the other countries.

We do know that the more knowledgeable an individual has regarding investments, the more likely that her return will be higher. Thereby, those who are financially illiterate can’t be expected to do as well as an honest financial advisor.

So, in conclusion, I am re-thinking my own story and altering my recommendations based on the results of this study. Though it is preferable for people to handle their own portfolios if they are inclined and financially sophisticated, a subset of our population simply is not suited to the task because they are financially illiterate. They are most likely those with less education, but not necessarily so. Others simply have no interest. For them, a financial advisor is better because there really is no other option.

For More:

Financial Illiteracy Is the Reason Most Americans Fail Financially

How We Become Financially Literate

Investment Knowledge versus Literacy