How to improve financial decisions

How to improve financial decisions
15 April 2013

A new study by Harvard Business School proves what cashy has been saying through our articles on empowerment and behavioral finance and Nima’s various radio and TV interviews, financial literacy alone is not enough to deter us from making poor financial decisions. According to the Harvard report: “Financial literacy and cognitive capabilities are convincingly linked to the quality of financial decision-making, influencing savings, stock-picking, and avoidance of outright financial mistakes. Yet, there is little evidence that education intended to improve financial decision-making is successful.”

The Harvard researchers found: “that state mandates requiring high school students to take personal finance courses have no effect on savings or investment behavior.”

However, the authors, Shawn Cole, Anna Paulson, and Gauri Kartini Shastry, found: “additional training in mathematics leads to greater financial market participation, more investment income, and better credit management, including less bankruptcy and fewer (home) foreclosures.”

Mathematical thinking

I’ve just finished a course on Mathematical Thinking, given as a Mooc, by Professor Keith Devlin of Stanford University. Has this improved my financial decision making? Time will tell but what I can state is that every time I do a supermarket shop I know more or less to the penny how much the total bill will be when I get to the checkout, as every item goes into the trolley I mentally add the amount and continue to total up the amount I am spending as I wander through the shopping aisles. The same applies when I buy a new pair of shoes, or shirt, instantly I am aware of how much cash I will have left in my wallet or, if paying by debit card, how much will be left in my bank account once I have made the purchase.

Does this mental arithmetic improve my financial behavior? It certainly helps me avoid overspending against my budget, or spending what I do not have. So yes, I do believe math ability helps me avoid mistakes, in-fact researchers Agarwal and Mazumder found that: “individuals with low measured math abilities are more likely to make a range of costly financial mistakes.”

Understanding the numbers helps us to calculate the compound interest on loans and nasty credit card bills, and thus avoid costly mistakes, as the Harvard researcher’s state: “those that make the biggest math mistakes save the least and borrow the most.”

Financial literacy is far more than understanding a glossary of financial terms (although again this is important), it is literally doing the math. Take for example two of the three standard questions used to diagnose financial literacy, pioneered by Lusardi and Mitchell (2011): “What is the future value of $100 saved over five years at a 2% interest rate? And how does the real value of savings change in an environment with 1% interest and 2% inflation?”

Test your knowledge

Try these questions by Lusardi and Mitchell

1) “If the chance of getting a disease is 10 percent, how many people out of 1,000 would be expected to get the disease?”

2) “If 5 people all have the winning number in the lottery and the prize is 2 million dollars, how much will each of them get?”

Respondents who gave the correct answer to either the first or the second question were asked:

3) “Let’s say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?”

4) In a sale, a shop is selling all items at half price. Before the sale, the sofa costs $300. How much will it cost on the sale?

5) A second hand car dealer is selling a car for $6,000. This is two-thirds of what it cost new. How much did the car cost new?

How confidant where you with your answers?

Respondents in England, as in the United States, show a low level of numeracy: only 11% of UK respondents are able to answer all five questions correctly.

What can you do?

The Harvard study results do not imply that financial literacy does not matter, or that financial education can never be effective. In fact I consider them very valuable, however without the requisite math ability and understanding of our cognitive biases they are not as effective as they could be.

To improve your math thinking, you could start by mentally adding up the cost of everything you put into your shopping basket as you make your way around the supermarket and see how close you are when the final total is rung up at checkout – try it, it is quite fun and can be satisfying when you are close to the amount you must pay.

Help your children with math homework or play a math board game. Try sudoku to sharpen your mathematic skills. Dartmouth College has some useful downloadable resources - Basic Mathematics through Financial Literacy.  Or as I did, consider joining an open course on math thinking.

Do you feel math ability is one of the reasons you make good (or bad) financial decisions? Remember there are no stupid questions in personal finance. Ask and ask again until you understand fully. Share your questions with the cashy community as a your say or in the comments sections.

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Head of Behavioral Finance
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