A Little Financial Knowledge is a Dangerous Thing

The Citi Smith Barney chap at my local Citibank branch is very sweet. Whenever anybody asks to open a brokerage account, he tells them that he’s not a discount brokerage, and that there are lots of discount brokers like E*Trade who can provide brokerage services at a much lower cost. But I have a feeling that a discount broker might not actually save you money. Dean Baker explains, in the context of talking about cuts in capital-gains taxes:

There is one other important point worth noting about the [lower] capital gains leads to more taxes story. Presumably the greater collections are supposed to come from people selling their stock or other assets more frequently. This means more fees for the financial industry, but is this what we really want to promote. The fees from these trades are a drain on people’s investments. There is a lot of research showing that active traders typically lose money.

When a stock trade costs less than a latte, the barriers to trading in and out of stocks become so low as to be all but nonexistent. And that’s not necessarily a good thing at all.

Lauren Willis at the Loyola Law School in LA takes this argument one step further, and says that consumers shouldn’t even bother with financial literacy:

The pursuit of financial literacy poses costs that almost certainly swamp any benefits. For some consumers, financial education appears to increase confidence without improving ability, leading to worse decisions. When consumers find themselves in dire financial straits, the regulation through education model blames them for their plight, shaming them and deflecting calls for effective market regulation. Consumers generally do not serve as their own doctors and lawyers and for reasons of efficient division of labor alone, generally should not serve as their own financial experts. The search for effective financial literacy education should be replaced by a search for policies more conducive to good consumer financial outcomes.

I do think that it’s worth taking an empirical look at the outcomes of financial education: if it doesn’t make people better off, then it’s probably not a good idea. And I also think that any intuitions I might have about the usefulness of financial education are pretty useless, since a lot of things which are obvious to me turn out to be really difficult for most people to understand. There’s a lot of ignorance out there:

Olivia Mitchell and Annamaria Lusardi found many people do not even have the most basic financial knowledge. Most people do not know the difference between debt and equity, yet are responsible for saving and investing for their retirement. We have a population of people responsible for their financial future and ill-equipped to do so.

And we’re not just talking about saving and investing, either: we’re also talking about home buying. In my experience, almost nobody understands the concept of opportunity cost or is capable of really internalizing the idea that renting can genuinely be cheaper than buying. Rent is always considered "wasted", while interest payments (not even principal payments) on a mortgage are considered, well, not wasted.

In general, I’d say that financial education is worthwhile only insofar as (a) it actually works, and (b) it not only gives people new information but also hammers home to them that even after their education they still know almost nothing and can’t expect to beat the market or make huge amounts of money by doing things like buying a large house with a large mortgage. What I call "financial wellness" is basically the art of spending less than you earn, not being greedy, and minimizing indebtedness. Learning about the ins and outs of the stock market is probably going to be more damaging than useful, much of the time.

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2 Responses to A Little Financial Knowledge is a Dangerous Thing

  1. investing says:

    you are so right about this. I little knowledge is definitely dangerous. People do not know how to invest their money.

  2. investing says:

    you are so right about this. I little knowledge is definitely dangerous. People do not know how to invest their money.

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