Our mission at The Motley Fool is to educate, amuse, and enrich. We do this because we think -- no, we know -- that people make better financial decisions when their financial literacy grows.
The idea might seem impossible to refute. But Lauren Willis at Loyola Law School has persuasively done just that. In a paper titled "Against Financial Literacy Education," Willis explains that there's "no reliable empirical evidence that financial-literacy programs are effective."
To the contrary, there are numerous examples of programs backfiring. For example, "a survey of high school seniors has consistently shown that financial education does not increase financial knowledge among high-school students and that students who take a personal finance course 'tend to do a little worse ... than those who do not.'"
Then there's this: "A study comparing bankruptcy debtors who received financial training with those who did not found that, once controls for other differences between the groups were added, the training was associated with a small negative effect on outcomes."
Or how about, "A program to teach low- and moderate-income consumers about money management and Internet banking ascertained one year afterward that 'members of the treatment group were less likely to plan and set future financial goals at follow-up than they were at baselines.'"
And on and on.
There are several reasons for these outcomes. The quality of financial education is poor. Students are uninterested. Financial products innovate faster than education can keep up. But this line from Willis' paper that really caught my attention:
For some consumers, financial education appears to increase confidence without improving ability, leading to worse decisions.
That one line sums up the majority of financial problems people run into. All too often, financial knowledge in itself isn't enough. The emotional intelligence of knowing when -- and when not -- to put that financial knowledge to use is far more important.
Examples of otherwise smart people making horrendous financial blunders abound. In 1998, the hedge fund Long Term Capital Management, staffed thick with Ph.D.s and two Nobel laureates, exploded amid an almost incomprehensible amount of leverage. Behind the failure was raging overconfidence. "The young geniuses from academe felt they could do no wrong," wrote Roger Lowenstein in the book When Genius Failed.
Warren Buffett, whose Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) contemplated a bid for LTCM's failed portfolio, said this about firm's 16-person management team:
They probably have as high an average IQ as any sixteen people working together in one business in the country ... just an incredible amount of intellect in that group. Now you combine that with the fact that those sixteen had extensive experience in the field they were operating in ... in aggregate, the sixteen probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worths in the business ... And essentially they went broke. That to me is absolutely fascinating.
LTCM is an example of financial education being overridden by a swamp of overconfidence, hubris, and a lack of common sense. Wall Street in general is another. The folks who ran Citigroup (NYSE: C ) and AIG (NYSE: AIG ) had plenty of financial education. But in general, they lacked the humility to realize the danger of what they were doing. One has to assume their top-notch pedigrees and financial educations contributed to that lack of humility.
Another example of financial education leading to poor financial decisions is the mutual fund industry. It's probably the most frequently cited financial statistic, but bears repeating: The overwhelming majority of actively managed mutual funds underperform market averages. Those humble enough to invest in index funds and never look back will broadly outperform those whose financial intelligence alone has fooled them into believing they can beat the market.
There are, of course, examples of those who get this right. Two years ago, I interviewed hedge fund manger Mohnish Pabrai, whose track record puts him among the top money managers of the past decade. Pabrai doesn't use analyst teams. He doesn't use complex spreadsheets. There are no Bloomberg terminals in his office. I'd be surprised if he owns a calculator. When I asked him what his edge was, he replied, "Control over my emotions." That's it? I asked. "It's huge. You'd be surprised."
Pabrai has extensive financial education. But the emotional intelligence that he applies to that education allows him to handily beat the market, while so many others fail keep up with the averages.
So what's the solution to the downside of financial literacy? I don't think less financial education is the key, whatever Willis' paper might imply. If anything, I think we need more financial education that first and foremost teaches about the emotional constraints of finance.
It doesn't help to know what an APR is unless you're also taught that the people offering you debt rarely have your best interest at heart. Knowing how to read a balance sheet is useless, unless you also learn that following the market herd can lead you to slaughter. And an understanding of compound interest won't help you much unless you also know that recency bias -- giving the most weight to what just occurred -- can fog your view of the future.
Alas, those topics are difficult to teach. Most of the people who have mastered the emotional aspect of finance were born with that predisposition. But I'm too optimistic to think it's a lost cause. If I could make one recommendation to financial educators, it'd be this: Drop every financial course that includes Greek symbols, and replace it with a course on financial psychology.
What do you think?
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
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