What is financial literacy?
Financial literacy is about understanding how money works. Many economists assume that people understand concepts like compound interest and risk diversification. However, research says most people do not.
In 2004 Professor Annamaria Lusardi from George Washington University and Professor Olivia S. Mitchell from Wharton University set out to learn what people knew about money by asking them three financial literacy questions.*
What did the test results find?
Lusardi and Mitchell found that in total, only 30 percent of respondents got all three answers correct. The test looks at three elements of personal finance:
Question one relates to compound interest. Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.
Question two is about inflation which is the increase in the cost of goods and services over time.
Question three concerns investment diversification. This is a risk management technique that mixes a wide variety of investments within a portfolio.
These questions have now been used in more than 20 countries to measure financial knowledge.
Comparisons of results across countries have demonstrated that financial illiteracy is a global problem. Results show that financial literacy peaks in middle age and that women consistently score lower than men.
The reasons behind financial illiteracy in women are vast and complex. This is something I hope to contribute towards answering in a few years once PhD is complete.
What’s being done to improve financial literacy?
To help Australians learn more about how to manage their money, the Australian Securities and Investments Commission (ASIC) set up MoneySmart.
MoneySmart offers tips on dealing with the ups and downs of life such as losing your job, having a baby, divorce or separation, buying a home, losing your partner as well as a section designed for teachers to use in the classroom. I use it often.
*Lusardi and Mitchell’s survey questions were incorporated into the United State’s ‘Health and Retirement Study’ (2004). Over 30,000 responses were collected.