The Importance of Education

Robert Shiller, he of the Case-Shiller Index (and therefore a reasonable symbolic candidate for 2008 Man of the Year, were it not for a certain presidential election), has an op-ed in The New York Times advocating a government program to subsidize financial advice for anyone, particularly low-income people. There is a lot to like about this idea. In Shiller’s proposal, the subsidy would only apply to advisors who charge by the hour and do not take commissions or fund management fees, so they would have no incentive to steer clients into particular investments or into unnecessary transactions. It seems reasonable that, if they had access to impartial advice, some people might not have taken on mortgages they had no hope of paying back or, more prosaically, some people might do a better job of budgeting and take on less credit card debt.

But I have one major reservation, which is that I’m not sure how good the financial advice would be. In my opinion, most financial advice floating around is worth less than nothing. To take the most obvious example: by sheer volume, the largest proportion of financial advice that exists (counting all advice that anyone gives to anyone else via any means of communication) is almost certainly advice on buying individual stocks, and the second largest is probably advice on choosing mutual funds. I am firmly in the camp that believes that whether or not stocks obey the efficent market hypothesis, it is not within the capabilities of any individual investor to identify stock trades that will have an expected risk-adjusted return higher than the market as a whole, net of transaction costs. I also believe it is not in within the capabilities of any stock mutual fund manager, and that all of the variation in risk-adjusted mutual fund performance can be explained by pure statistical variation. And even if I’m wrong about that, and there are a few exceptional fund managers out there, I don’t believe that any individual could distinguish the exceptional managers from the simply lucky ones; and even if he could, by the time he did he would be buying into a fund that had grown so big it was no longer capable of above-market returns.

If this is so, why doesn’t the market for financial advice take care of this problem?

Because that market has two major problems. First, you are unlikely to get rich advising people to buy a set of index funds and rebalance their portfolios every six months – not a lot of recurring business there. Most of the advice, as Shiller points out, comes from people who are biased – primarily people who are trying to sell you financial products that, in my opinion, are probably not good for you,* but also people trying to sell you books and magazines about which financial products you should buy.

Second, people want to believe there is a way to get rich. The idea that, given a sufficiently liquid market, anything you happen to know about a company (say, because you read it in The Wall Street Journal) is already priced into the stock price is deeply unintuitive to the human brain. And the idea that you can only rely on a very low real rate of return – basically, the yield on Treasury Inflation-Protected Securities – is something many people simply do not want to accept.

When you get away from investing in securities, perhaps there is more value that financial advisors can provide. For example, they could help explain the detailed terms of various financial products, or help people understand their spending patterns and come up with budgets. So on balance perhaps Shiller’s proposal would do more good than harm. But the risk is it would expose even more people to the sales pitches of financial services companies, which would no doubt multiply their marketing to independent financial advisors several times over. I agree that lack of financial understanding is a significant societal problem, but given the powerful interests involved, I find it hard to come up with a good solution.

* When I was an executive at my company, and “wealth management” specialists made the mistaken assumption that I and my co-founders had a lot of money, I saw a proposal from a major investment bank to buy a product that was guaranteed to return more than a major index of international stocks. The catch was that the return was based on the value of the index alone, and did not include reinvested dividends, and therefore in every historical period I could find for reference this product would have lost me money (relative to just buying an index fund tracking the same index). When pressed, the advisor said his bank didn’t have a position on whether or not this was a good investment. The other side of the trade was being taken by another party who was paying the bank a 3% underwriting fee; in other words, in aggregate the parties doing the trade were bound to lose money, and the bank was going to pocket its fee.

19 responses to “The Importance of Education

  1. I think there is a market for good financial advice, but it probably exists in high school, along the lines of “Save early and often, use debt for long-term purchases like houses, if a deal sounds too good to be true it probably is” etc. Actually I guess the advice would come best about 6 months after the person got their first job, when they realized they had to be a grown-up now, and had money to manage. Unfortunately those most likely to take the advice are those who don’t need me.

  2. The need for basic person financial education is critical in this country and elsewhere and it includes having the knowledge to determine when you are getting duped by the pros. I think this is exactly the point Prof. Shiller is making. Basic understanding of mortgage notes, banking rules, understanding the fundamental workings of basic finacial products, CDs, equities, fixed income, ETFs, credit cards etc. All of this is absent from most of the population’s knowledge set; it’s one of the reasons we find ourselves in the current economic condition.
    You miss the point: it’s about educating the public, not selling them the next “hot stock or international investment.”

  3. I think Shiller’s idea of public funded advice is a waste. Here are my reasons – a. In any other expertise based area (eg doctors, accountants, engineers, lawyers), there is a duty to work within boundary of expertise and to admit this boundary. In my 25 years, I have yet to come across an adviser who would admit this boundary. They may admit for example that they can only advise on mutual funds but not on shares but in every crisis including the current, not one has admitted that they have reached boundary of their expertise under the circumstances.
    2. When you go to an independent expert, you want two items of advise – what to do and what not to do. The advisers may be useful in telling people what to avoid rather than what to buy. Of course the client wants both. Therefore the advise is likely to be as harmful.
    3. I disagree with Bill’s point on education (Also, Shiller’s article is less about educating the masses). Great deal of losses were suffered by people who understood theory of financial products, many had PhDs and some even had Nobel prizes.

  4. Part of what Shiller identifies is basic mathematical illiteracy, especially but not only among low-income folks, which has two primary causes: the ineffectiveness of educational institutions that serve the disadvantaged (sometimes these institutions are ineffective per se, but as often they are ineffective at providing the vast array of support services that privileged children get from their parents, like tutoring and therapy and early childhood literacy); and the belief that it’s ok not to be mathematically literate (expressed by the innumerable people with college degrees who say, as they would not about reading, “I’m bad at math.” Can you imagine a teacher saying, “I’m bad at reading?”) So one part of teaching basic financial literacy would be teaching percents, fractions, compounding, and equations – just using something people actually care about rather than standard math textbooks, and at a time when they are particularly interested, as demonstrated by signing up for a class, rather than during 2nd period. When I taught HS math in a low-income neighborhood high school, I used a lot of financial examples; but my students had very limited experience of situations where compounding interest, etc, mattered, and I don’t know enough about ETFs or mortgage notes to teach about them accurately. It’d be great to have a ‘math for finance’ series as a Saturday/evening class at a community center, paired with a mechanism for students to get individual advice at the same place.

    I do think, as someone who went to decent public schools and had educated, financially literate parents, that I knew far too little about financial products when I graduated from college. I imagine the problem is worse for people with fewer ambient resources, and thus I think Shiller’s idea is a pretty good one. The critique you’re making is aimed at investment advisers; my understanding is that Shiller wants to subsidize advice covering what financial products are, how to judge mortgage terms, options for improving your cash flow so you don’t need to use payday lenders. Basic advice, not investment advice. I imagine there are some non-profits out there doing this already, and presumably the best way to organize this would be that any company/agency that provides basic, subsidized financial literacy consulting would be barred from offering commission-based financial services at all.

  5. Charles R. Williams

    What complicates financial planning is taxes and inflation. What would vastly simplify financial planning for the average person is shifting to consumption based taxes (VAT) and preserving the value of the dollar. The average guy saves up a down payment for a house, pays off his mortgage over 30 years accumulates maybe one or two years salary after the kids leave the house and relies on Social Security and assistance from his kids to support himself through retirement. This does not need to be complex. The tried and true rules of thumb work well: borrow to buy a house, try to pay cash for your car, avoid borrowing for consumption, work hard, save what you can in government insured bank accounts, stay married.

    This works for about two-thirds of the population.

    Another 25% of the population needs to understand the principles of systematic risk, diversification and market efficiency. These people have enough saved to justify more complex investments like mutual funds.

    Finally, there is the small number of people who need to understand more and could possibly benefit from financial advice. Generally, they don’t need this knowledge until their thirties at the earliest.

    Inflation and our tax system turn everyone into a potential sucker for the people who aggressively market financial products.

  6. I agree with your thoughts.

    One reason financial advisors are so useless (on average) is that they are fairly ignorant. They may know about diversification and ‘don’t panic’ – but the former is not good enough and the latter is meaningless.

    They don’t grow. They don’t think for themselves. They never suggest that individual investors use conservative option strategies to protect their holdings against any significant loss. They are afraid to think outside the box.

  7. Michelle Singletary of the Washington Post has been attempting for years to educate her readers in the basic rules Personal Finance — essentially for free (or, at least, for the purchase price of a WaPo subscription).

    http://www.washingtonpost.com/wp-dyn/content/linkset/2005/03/24/LI2005032400142.html

    Evidently, there are many Americans she was unable to reach. It is hard to imagine how additional money is going to improve the financial IQ of the general public.

  8. I am a CPA and have many stories to tell similar to yours about the product with reinvested dividends and a 3% fee. I’ve seen such junk out there it’s amazing. Tax shelters with phony tax shelter opinions, you name it. One point of disagreement, TIPS. I wouldn’t touch them with a ten-foot pole. Who determines the inflation rate, what is their taxability? You’re much better off with “Stocks for the long-run”. Interest is something the government pretends to pay you to steal your principal. Bonds, bah humbug

  9. About the 3% deal: this, sir, is why they are called financial “products”.

  10. On average, actively managed money underperforms the market by the cost of active management. Throw it all into IWV. Most financial planners are incapable of performing simple algebra.

  11. We must all be educated. But we don’t need just more Information, we need access to change and transformation. We need to know how the world works, and what innovation is. We don’t just need dates and formulas, we need to be taught how to Live.

    Jordan.
    http://www.theriverjordan.net

  12. I would describe what most financial planners do as “Financial Chiropracty”

    Works fine as long as there is no REAL problem to deal with.

  13. Are people who earn less than 45k a year who take on 400k mortgages to by exerb McMansions really making “poor investment decisions”? The vast majority of low-income Americans make few financial decisions at all let alone anything that could be characterized as an “investment decision”. Spare me. An enormous real estate bubble and easy credit allowed a bunch of people in the 30-45k a year income range to live briefly like six-figure earners. And then the bottom dropped out. Having a 30 year fixed mortgage (as opposed to some alice in wonderland sub-prime concoction) on a home worth 100k less than when you bought it a year ago is still swimming underwater. Surely one doesn’t need to consult an expert to figure that out.

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  15. Education is very necessary in Financial sector. Because half knowledge is very risky.If you want to build your career in that field first go for better financial institutes and fulfill all basic requirements.

  16. As mentioned in the original article, the main problem with most “financial advisor’s” and most “financial advice” is that it is geared toward selling products to clients. It really has nothing to do with what the individual wants. People want and need unbiased advice provided on an hourly basis. The National Association of Personal Financial Advisors (www.napfa.org) has preached this for years. The time has come to reform the financial services industry away from product sales. People don’t need products, they need advice!

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  19. Thanks for taking the time to explain this in a way thats so easy to understand.