Ready for a Challenge?

Last month I wrote about a recent article, Why We're Not Wired for Successful Retirements by Philip Moeller, that was based on a financial literacy test given to consumers in Chile. I noted how many of those surveyed misunderstood the power of compound interest. Since then, blog readers have asked about the other questions. So, here they are, reprinted directly from the article. Only 68 out of nearly 14,250 tested answered all six correctly. See how you do. (The correct answers follow, but no peeking!)

1. Chance of Disease: If the chance of catching an illness is 10 percent, how many people out of 1,000 would get the illness?
2. Lottery Division: If five people share winning lottery tickets and the total prize is two million Chilean pesos, how much would each receive?
3. Numeracy in Investment Context: Assume that you have $100 in a savings account and the interest rate you earn on this money is 2 percent a year. If you keep this money in the account for five years, how much would you have after five years? Choose one: more than $102, exactly $102 or less than $102.
4. Compound Interest: Assume that you have $200 in a savings account, and the interest rate that you earn on these savings is 10 percent a year. How much would you have in the account after two years?
5. Inflation: Assume that you have $100 in a savings account and the interest rate that you earn on these savings is 1 percent a year. Inflation is 2 percent a year. After one year, if you withdraw the money from the savings account, you could buy more/less/the same?
6. Risk Diversification: Buying shares in one company is less risky than buying shares from many different companies with the same money. True/False

Answers:

1.  100
2. 400,000 pesos
3. More than $102
4. $242
5. Less
6. False

How did you do?

Is Cash in the Pocket Better Than Waiting for More?

In a recent article, Why We're Not Wired for Successful Retirements, Philip Moeller explores the psychology behind the answers to that question as documented in new research by Justine Hastings of Yale University and Olivia Mitchell of the University of Pennsylvania. Their paper for the National Bureau of Economic Research reveals the results of two tests they conducted to ascertain why people often fail to make sound financial decisions.

Interestingly, the findings Moeller reports on were based on research with consumers in Chile, not the United States. The first test involved posing six relatively simple questions to gauge respondents’ financial literacy. (Nobody scored 100 percent.) In the second test, people were offered the option of receiving the equivalent of about $8 if they filled out a shopping questionnaire right away, or a larger amount of money if they took the questionnaire with them and mailed it back within four weeks. (Not surprisingly, more than half the people chose the immediate payment; 30 percent chose to wait for more money and 17 percent took the questionnaire with them, yet failed to return it.)

Said the researchers, "We find that the impatience measure strongly predicts respondents' self-reported retirement saving and health investments. Financial literacy is also associated with more retirement saving, but it is less closely associated with sensitivity to framing of investment information."

For me, the research’s real lesson for those saving for retirement comes from reviewing the question most people answered incorrectly. Addressing compound interest, the question asks: Assume that you have $200 in a savings account, and the interest rate that you earn on these savings is 10 percent a year. How much would you have in the account after two years? Not too many people came up with $242. (You earn $20 the first year on 200, then $22 on $220 during the second year.) Understanding the long-term power of compound interest in tax-deferred savings accounts is crucial to motivating investors to sacrifice today for their benefit tomorrow.

The need for immediate gratification, a uniquely American characteristic, can be difficult to overcome, but doing the math may convince you.