A hot topic in economics research right now is financial literacy. Survey after survey shows that most investors do not understand the most basic concepts. Today's WSJ summarizes some research (gated) by Brigitte Madrian of Harvard and others. The research focuses on three key concepts: the power of compounding interest, the impact of inflation on rates of return, and the importance of diversification. In a survey of the general population, only 30% were able to demonstrate they correctly understood all three concepts.
Why is this a problem? First, financial choices facing individuals are becoming increasingly complex. If the general public has a hard time with simple compounding, what are they to do about decisions about annuities or, heaven forbid, derivatives? Second, companies are increasingly shifting investment decisions to their workers by emphasizing defined contribution pensions over defined benefit plans.
I am currently working on a research project with three NC State colleagues that explores financial literacy and understanding of Social Security and private pensions at five large organizations. The bad news is that although our sample is highly educated, the respondents do poorly on our survey about financial and pension knowledge. The good news is that after attending retirement seminars offered by their employers, they know a lot more. Also, it appears they rethink many decisions about retirement after obtaining this knowledge.
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