5  Financial literacy

Financial literacy is a term with many definitions in the literature. One definition is offered by Remund (2010):

Financial literacy is a measure of the degree to which one understands key financial concepts and possesses the ability and confidence to manage personal finances through appropriate short-term decision-making and sound, long-range financial planning, while mindful of life events and changing economic conditions.

Although this definition relates to domains such as confidence and planning, most tests of financial literacy are narrower tests of financial knowledge (Fernandes et al. (2014)).

The following questions are classic questions to test financial literacy.

  1. Suppose you put $100 into a no-fee savings account with a guaranteed interest rate of 2% per year. You don’t make any further payments into this account and you don’t withdraw any money. How much would be in the account at the end of the first year, once the interest payment is made?

  2. Imagine now that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, would you be able to buy more than today, exactly the same as today, or less than today with the money in this account?” [More, Same, Less]

  3. Buying shares in a single company usually provides a safer return than buying shares in a number of different companies. [True, False]

  4. An investment with a high return is likely to be high risk. [True, False]

  5. Suppose that by the year 2020 your income has doubled, but the prices of all of the things you buy have also doubled. In 2020, will you be able to buy more than today, exactly the same as today, or less than today with your income? [More, Same, Less]

The first three questions are used in many surveys globally. Those three questions plus the latter two are currently asked as part of the Household, Income and Labour Dynamics in Australia (HILDA) Survey (Wilkins and Lass (2018)), a household-based panel study conducted annually in Australia. The questions cover:

Many people have low financial literacy.

In the 2018 HILDA survey, 42.5% of participants got all five of the above financial literacy questions correct. The proportion of correct responses for each question was:

Remember that all except the numeracy question were multiple choice.

The Australian Financial Attitudes and Behaviours Tracker, a periodic survey run by the Australian Securities and Investments Commission (ASIC), consistently finds that only one-third of respondents have heard of and understand the risk-return trade-off (Australian Securities and Investments Commission and EY Sweeney (2018)). Only 40% have heard of and understand the concept of diversification.

You can see how misunderstanding of these concepts could affect borrowing, savings, investment and insurance decisions. To determine the benefits of savings or costs of borrowing, you need base numeracy and need to understand inflation. Diversification is a core principle to achieving investment returns at lower risk.

There is considerable research demonstrating a correlation between financial literacy and financial wellbeing, as well as other financial outcomes. Financial literacy is correlated with day-to-day financial management skills, financial market participation and investment, the holding of precautionary savings, planning for retirement, cheaper mortgages, more regular refinancing of debt, and lower transaction costs, among other things.

However, the evidence of a causal relationship between the financial literacy and financial outcomes is debated. We will discuss this debate in Chapter 23.