In 2004, two US economists named Anna Maria Lusardi and Olivia Mitchell set out to measure what people knew about basic financial principles. They attached the following 3 questions to a 2004 Health and Retirement Study being conducted in the US*.
1. Suppose you have $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
A) More than $102. B) Exactly $102. C) Less than $102. Or, D) I don’t know.
2. Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After one year, how much would you be able to buy with the money in this account?
A) More than today. B) Exactly the same as today. C) Less than today. Or, D) I don’t know.
3. Do you think the following statement is true or false: buying a single company stock usually provides a safer return than a stock mutual fund?
A) Yes. B) No. Or, C) I don’t know.
If you got all of them right (answers below) you are in a minority; only 30% of the 20,000 respondents managed it and there were also wide disparities between demographic groups. The numbers are pretty similar around the developed world and have not improved much in the last 15 years.
Why does this matter? Financial ignorance carries a hefty price tag. People who do not understand interest compounding, for example, spend more on transaction fees, run up bigger debts, and incur higher interest rates on loans. They also end up borrowing more and saving less; they remain with utility and service providers who offer poor value and they are much more prone to being victims of financial fraud and misselling. A lot of focus has been on improving numeracy, but there are equally large knowledge gaps around the basic concepts of inflation and diversification.
With the advance of behavioural economics we now know that the decision making process is filled with flaws and biases, and that presumptions of rationality are much misplaced. Recently some Wealth Management firms have introduced behavioural coaching to help clients to overcome these biases and improve their investment decisions. Most firms have also tried to educate clients about the benefits of diversification and investing for the long term.
But in the same way that economics made assumptions about human behaviour that were out of line with how we think and make decisions, Wealth Managers also make assumptions about clients and their attitudes to money. We spend a large amount of time determining clients’ sources of wealth but little, if any, understanding the psychology of their wealth. We assume, broadly speaking, that our clients have similar relationships with their money and we tend to equate wealth with financial literacy. We may drill down into educational level and financial experience, but this is for risk profiling purposes and tells us very little about how clients feel about money.
Our attitude to money is formed over our lifetime as genetic, cultural and learned biases interact with knowledge and experience. And, for any given amount of wealth, the journey to acquiring that wealth will also determine how we feel about it. As an extreme example, a regular saver and a lottery winner with the net worth are most likely to have very different feelings about money. Even in the same family, siblings often have very different attitudes and spending patterns.
Money hasn’t existed for long enough in evolutionary terms for humans to develop a specific neural system to deal with it. So we use parts of the brain that were designed to process other activities – we co-opt mental tools that were designed for different purposes to handle money, and this leads to sub-optimal behaviours and counter-intuitive results.
At its heart, our relationship with money is complex, emotional and personal, with many beliefs being formed at a very young age. So, while we may think that our mandate is simply to manage wealth in accordance with our clients’ stated objectives, we never really explore the deeper relationship between clients and their money. If we knew how they felt about money, what it was in relation to money that made them happy and what made them anxious, then surely that would make us better wealth managers.
Answers – A, C, B
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