Why You Shouldn’t Take Those Financial Literacy Tests Too Seriously

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By Walter Updegrave, RealDealRetirement @RealDealRetire

In case you haven’t been paying attention, April is Financial Literacy Month. Which means you’ll likely be invited in the next few weeks (if you haven’t been already) to try your hand at any number of tests theoretically designed to gauge your financial acumen. But if you take one of these exams and don’t ace it—or manage even a passing grade—I wouldn’t get too worked up about it, as they don’t necessarily measure all the skills that count when it comes to making sound financial decisions.

A recent press release from the National Financial Educators Council (NFEC) informed me that the average grade on its 30-question National Financial Literacy Test was just 64%. My initial reaction was to bemoan the lack of personal finance knowledge in this country…until the release went on to note that the question the fewest test takers answered correctly (just 28% got it right) was this one:

If I invest $100 per month starting at age 21, and that money earns a 7% annual return, how much will I have after 70 years?
A. $138,957

B. Between $150,000 and $225,000
C. More than $1.5 million
D. None of the above

The correct answer is C. More than $1.5 million.

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But wait a minute. This question has little, if anything, to do with with assessing financial literacy. It’s an arithmetic problem. All it shows is whether you can calculate the value of 840 monthly investments of $100 each spread over 70 years compounded at an annual rate of 7%. (Which, by the way, according to my Excel spreadsheet, requires less than 66 years, not 70, to accumulate more than $1.5 million.)

I suppose you could argue that this question gets at whether one understands compound interest or how investing small sums over a long period of time can add up to big bucks. But there are better ways to do that. Given the fact that this question requires someone to compound a monthly sum over a period of 70 years, or 840 months, it doesn’t surprise me at all that this question would elicit so many wrong answers.

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I had a similar gripe about the answer to another of NFEC’s questions:

Before I begin investing, what systems should I have in place?
A. Expert-level knowledge about any investment you’re considering
B. A trusted team of professionals who can give you advice
C. Risk Capital (money you can afford to lose)
D. All of the above

The correct answer, according to NFEC, is D. all of the above.

All of the above? Really? Hey, I’m all for boning up on personal finance and investing fundamentals as a prerequisite for investing. But do you really need to acquire expert-level knowledge before you can even begin contributing money to your 401(k)? And even if you’ve done that, apparently you’re still not qualified to invest on your own. If NFEC is to be believed, you also need to consult not just one professional, but a team of pros (and also, presumably, pay this team). Call me irresponsible, but in this era of index funds, target-date funds, managed accounts and robo-advisers, this seems like a bit of overkill to me.

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Just to be clear: I’m not looking to single out NFEC (or denigrate its educational efforts). I have issues with other tests as well. For example, one of the questions in the Standard & Poor’s Global Financial Literacy Survey asks:

Suppose you have some money. Is it safer to put your money into one business or investment or into multiple businesses or investments?
A. One business or investment
B. Multiple businesses or investments
C. Don’t know
D. Refused to answer

I realize that the question is meant to test whether people understand the benefit of diversification, and that the answer the test is looking for is B. Multiple businesses or investments.

But I have to admit that after reading the question my first thought was: Is “safer” the right word here? Some might take this to mean that both approaches are safe, but one is safer than the other. I wouldn’t characterize any investment in a business or security like a stock, bond or mutual fund as safe, in the sense of not involving or likely to involve danger, harm, or loss. For a second I thought maybe this was some sort of trick question. Which is why I’d say diversification is better thought of as a way to help manage risk. Hence, I think the wording of a similar question in a recent Alliance Bernstein study makes more sense: When an investor spreads his money among different investments, does the risk of losing money increase, decrease or stay the same?

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But such quibbles aside, the bigger concern I have with many financial literacy tests is that they can give you a false impression of what it takes to be financially successful. I agree that it’s important to understand key concepts like inflation, diversification, interest rates and compounding. For example, studies show that people who don’t grasp the idea of compound interest spend more on transaction fees, borrow more and incur higher rates on loans.

But there’s more to financial success and building wealth than mastering such concepts. Common sense, critical thinking, a healthy dose of skepticism—what I call financial street smarts—are just as crucial, if not more so.

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Comprehending the concept of compounded returns is fine, but it’s just as important to understand that saving is a surer way to build an adequate retirement nest egg than investing and to realize that, whatever returns the financial markets deliver, you’ll likely get a larger share of them if you stick to investments with low fees. A skeptical attitude also helps. If someone is touting a “safe” or “low-risk” investment that’s projected to yield a high return, “too-good-to-be-true” alarm bells should automatically go off.

Finally, I’d add that non-financial qualities like perseverance (say, in sticking to a saving and investing) and resourcefulness (for example, finding innovative ways to pare expenses in retirement if necessary) can play a major role in achieving financial success. I’d also throw in humility, in the sense of knowing your limitations. You don’t have to look far to find examples of highly financially literate hedge fund managers and other masters of the investing universe who fell prey to overconfidence and lost billions of their own money as well as their investors’ dough.

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So during breaks from your financial literacy celebrations this month, by all means take the time to brush up on the fundamentals of personal finance and maybe even take a stab at a financial literacy test (like this one and this one, both of which I created as much for fun as educational purposes). Whether you excel or not, however, remember: Technical knowledge about finances is fine. But to succeed, it also helps to have common sense, a bit of skepticism, stick-to-it-iveness and an awareness of your own limitations.   (4/13/16)

Walter Updegrave is the editor of RealDealRetirement.comIf you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.

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