Financial Education and Financial Decision-Making

People are living longer. One of the consequences from this is that we are going to have a longer retirement. A longer retirement requires a larger sum of money to finance. Several tax-favored retirement saving/investment plans were created to help people prepare for their retirement. These plans allow people to invest their savings in a number of financial products and the income is tax-deferred. However, the amount and complexity of financial products are increasing. hence in order not to jeopardize their retirement, sound financial decision-making is more important than ever.

A number of studies have shown that the level of financial education is closely related to the level of financial literacy. And people with higher level of financial literacy tend to make better financial decisions. Therefore, financial education is an adequate tool to promote effective financial decision-making.

How do people make decisions?

To understand the connection between financial education and financial decision-making, we first have to understand how people make decisions.

Classical economics theories assume that people always act rationally on the information available. From this notion, we can derive the efficient market theory. This theory states that if people act rationally on all the information available all the time, then the market is always efficient (Shiller 10). However, Shiller pointed out that "the stock market if anything but efficient" (11). Why is this the case? The only logical conclusion from this observation is that people, in fact, don't act rationally on the information available. If this is true, the how do people make decisions?

According to Knight, people make decisions base on the subjective probabilities they assign to certain events. In other words, people make decisions base on their "judgements" and "intuitions" (Knight 14-16). The reason is, many times during the process of decision-making, people are facing "events that are essentially unprecedented in nature, whose probability must be judged by thinking by analogy and induction" (Shiller 12). Knight, in Risk, Uncertainty, and Profit, called this type of event uncertainty, to distinguish it from events with known probability distributions, which he called risk. According to Knight's theory, factors that can affect "judgements" and "intuitions" will affect the process of decision-making. Therefore, the question we have to address is: What can affect "judgements" and "intuitions?"

Many times, people make decisions following the "conventional wisdom" (Shiller 8). They think, because other people are doing it, it must be good. The problem of following the "conventional wisdom" is that it might be wrong. Also, as Shiller pointed out, people have to interpret "conventional wisdom" in order to use it as a standard for decision-making (9). However, the definition of "conventional wisdom" is never concrete, in fact, it is very vague. One person's interpretation might be very different from the next.

The news media is another factor that affects people's decisions because it "play[s] a prominent role in generating our "conventional wisdom" (Shiller 9). A well-written story often catches people's attention and "can have powerful impact on public thinking" (9). Research also suggest people pay a lot of attention to the media when it comes to learning about finance. Beverly, Hilgert and Hogarth found that "households [prefer] to learn about money management through media sources (television, radio, magazines, and newspapers)" (319).

As mentioned before, people don't like to deviate too much from the "conventional wisdom," i.e. the norm. There might be a conformity pressure that drives people to follow the norm (Shiller 11). Shiller observed, even experts and professionals are subject to conformity pressure, not just the public. This pressure is motivated by, as Shiller explained, the desire for members of the group to "preserve their status within the group" (11).

Perhaps the most obvious factor that can affect "judgements" and "intuitions" is a person's experience. Their development "requires years of experience in "problem-solving" (Khatri and Ng 4). This is also where education comes into play. Since education, formal of informal, makes up a relatively large portion of a person's experience, naturally, it must also play an important role in the development of "judgements" and "intuitions."

While on the subject of education, we will also define the word "education" here. According to the Merriam-Webster online dictionary, "education" means "the knowledge and development resulting form an educational process." This definition is a good starting point. We must also be aware that "[t]here is a difference between providing information and providing education" (Beverly, Hilgert and Hogarth 321). Providing information is just providing the facts, e.g. the current interest rate. Education is the next level, it "require[s] a combination of information, skill-building, and motivation to make the desired changes in behavior" (Beverly, Hilgert and Hogarth 321). Education is a process with an intention of changing behavior. The effectiveness of education changing behavior is the subject of this paper.

What is a good decision?

Decisions are evaluated ex post. In other words, the decision itself has no value. The value of a decision comes solely from the results, or the expected results, it yields. To say a decision is good is to say that the decision yields, or is likely to yield, good results. Therefore, to study the quality of a decision, we must answer the question: What is a good result?

Since the focus of this paper is to examine the connection between financial education and financial decision-making, we will follow the financial standard - a result is good if it increased a person's financial well-being.

What is the evidence?

It is logical to assume that the complication of financial products would suggest a higher level of financial literacy, either because people feel the need to understand more or the complication is a result of higher level of financial literacy. however, data shows the opposite. Empirical evidence suggests that the general public is not well-educated in finance and the level of financial education varies among demographic groups.

People approaching retirement or already retired have very little basic financial knowledge. A study shows that only 50% of this group understands compounding interest and inflation and only one-third understands the concept of risk diversification (Lusardi, Financial literacy 6). The lack of financial knowledge makes this group particularly vulnerable to financial fraud. According to an interview with Eric Stein, a man who is convicted for running a Ponzi scheme, "scammers" usually go after people hitting close to retirement or who have recently retired" (Ruffenach 6). Aside from the lack of financial knowledge, another reason that this group is more vulnerable to financial fraud is that this group of people "don't have the business opportunities they had when they were younger," as Mr. Stein explained (Ruffenach 7).

Women, generally, when compare to men, have less financial knowledge. The difference is greatest with regard to risk diversification (Lusardi, Financial Literacy 11). The impact of this difference is especially stroung after the death of a spouse. Lusardi's description - "a husband's death can precipitate his widow's entry into poverty" - should give us a sense of the severity (Saving 3).

Financial knowledge varies widely among people with different level of education. Only half the people with less than a high school diploma can perform simple calculation on interest rate and close to 20% don't know how. The large majority of people without a college degree fail to understand the concept of risk diversification (Lusardi, Financial Literacy 12).

Differences in financial literacy can also be observed across different racial groups. Only about half of African-Americans can perform interest rate calculation and an even smaller ratio among Hispanics (Lusardi, Financial Literacy 12).

One might think that, with a better education system today, at least the younger generation would have higher level of financial knowledge. this idea is very wrong, unfortunately. According to a Time magazine article, high school students' financial literacy test scores are dropping.

Even when we look at the demographic with higher level of financial literacy, the result is disappointing. Only one-third of this group "knows the relationship between bond pricing and interest rates, indicating striking ignorance of how assets are priced" (Lusardi, Financial Literacy 10).

It is clear that financial literacy is not common. However, what about the ability of making sound decisions. Are people making sound decisions? Empirical evidence suggests no.

Planning for retirement makes a huge difference. "[T]hose who plan [for retirement] have more than double the wealth of those who have not done any retirement planning" (Lusardi, Financial Literacy 13). However, a large number of people don't plan for their retirement. "Only 39 percent of workers in 2001 have tried to determine with some accuracy how much they need to save to fund their retirement" (Lusardi, Saving 4). When ask why they have not done any retirement planning, most respond that "it was too difficult and they did not know where to find help to do it" (Lusardi, Saving 4).

There seems to be difficulty in making good decisions even for those who did some retirement planning.

Many households are not saving enough to maintain the quality of life they are used to after their retirement. Some simply don't save enough for their retirement. A study suggests that "about half of working middle-class American households will not have fully-funded retirements [and s]ome will actually run out of resources very shortly after retirement" (Lusardi, Saving 3). The reason is that people fail to understand the concept of saving. most households started saving too late, either because they don't have enough until late in life or because they fail to recognize the importance of saving early in life. Statistical data suggests that even thought most households have a saving account, "fewer than half ... saved regularly out of each pay check" (Beverly, Hilgert and Hogarth 316).

The structure of a typical household's portfolio also gives us insight as to why many of them have little or no wealth close to their retirement. For many households, the majority of their wealth portfolio is their house. Many households "hold neither high return assets (stocks, IRAs, business equity), nor basic assets such as checking accounts" (Lusardi, Saving 2). Obviously, they are not making good financial decisions.

As we have seen, there is a healthy amount of statistical data that shows people are not well-educated financially and they are not making sound financial decisions (retirement decisions, in particular). Is there a connection between education and decisions? Empirical evidence suggests so.

People "who studied economics (in high school, college, or at higher levels) were much more likely to display higher levels of financial literacy later in life" (Lusardi, Financial Literacy 12). Furthermore, people with higher levels of financial literacy are more likely to plan for their financial future, i.e. their retirement. Retirement planning is a sign of good financial decision-making as it generally yields good results, as we have seen. Some many argue that people who want to plan for their retirement will be more interested in finance, hence naturally, they must have a higher level of financial literacy compare to other people. However, Lusardi pointed out that data suggests "it is [financial] literacy that affects planning and not the other way around" (Financial Literacy 14).

Households with higher level of financial knowledge are more likely to participate in the stock market. In the long run, stocks usually yield higher returns than other assets commonly held by households. As we have seen, the lack of participation in stock market is one of the reasons why so many households have very little or no wealth close to their retirement. similar to the above, it can be shown that it is financial literacy that encourages participation in the stock market and not the other way around (Lusardi, Financial Literacy 14).

"There are tremendous differences in wealth holdings for households on the verge of retirement" (Lusardi, Saving 8). The level of education, which can be a proxy to measure financial literacy, seems to matter here. "[H]ouseholds whose head is college educated have more than twice the wealth ... of households with high school education" (Lusardi, Saving 9).

People who attended retired retirement seminars are better off financially close to their retirement. It appears that, on average, there is an 18% gap in wealth between people who attended retirement seminars and those who don't. The difference becomes greater as we move toward the low end of the distribution and for people with the lowest level of education (Lusardi, Saving 14).

What types of education are more effective?

As we have seen, financial literacy matters in financial decision-making. Financial education can increase financial literacy. However, there are many types of financial education available, are they all as effective?

Most people prefer to learn about finance from three major sources: personal experience, friends and family and the media (Beverly, Hilgert and Hogarth 318). People who like to learn by doing would prefer to learn about finance from personal experience. Friends and family are regarded by many as trusted source for information. Therefore, people are more willing to learn from them. The media being one of the three major sources is really not surprising. As mentioned before, the media can affect behaviors by changing "conventional wisdom" (Shiller 9).

The effect of these sources on financial behavior is statistically significant. Households that reported acquiring financial knowledge from these sources score higher on financial practice indexes (Beverly, Hilgert and Hogarth 318).

One thing that is worth noting is that "just in time" sources - sources that are available to people whenever and wherever, e.g. the Internet - seems to have a larger effect on financial behavior. "Households that scored high on financial practices indexes where more likely than those scoring in the low or medium group to prefer the Internet as an information source" (Beverly, Hilgert and Hogarth 319).

Beverly, Hilgert and Hogarth also mentioned the idea of "teachable moment" (320). In order for people to take full advantage of the information provided, the information must be presented at the moment when people are most eager to learn. For example, providing purchase counseling to first-time homebuyers (Beverly, Hilgert and Hogarth 320). If the right information were presented at the "teachable moment," it is more likely that the information will bring the desirable behavioral change.

Does that mean education cause good decision-making?

In his interview, Eric Stein described a set of personal traits that he and other "scammers" look for when choosing their targets. He talked about people already in retirement or approaching their retirement. These people are easier to fraud as they are more desperate in earning enough wealth to fund their retirement. Dentist will fall for the scams because they want to be loved by other people. A little "sweet-talk" and they sure will bite. Entrepreneurs love to take risk. Anything that involves a large sum of money you can count them in (Ruffenach 6-7).

There is one thing that Mr. Stein never mentioned - education. So far, this paper have shown that there is a strong correlation between financial education and financial behavior. If that is the case, then Mr. Stein should have targeted people with less financial education, as they are more likely to make bad decisions. The only reasonable explanation is that, although there is a strong correlation, financial education is not the only contributing factor in the decision-making process.

As mentioned before, people make decisions based on "judgements" and "intuitions" and they can be influenced by many factors, education being one of them. In his book, Outliers: The Story of Success, Malcolm Gladwell explained that intelligence, in determining a person's success, is only important up to a certain degree. Using the same notion education is only important up to a certain degree in the decision-making process. In other words, there is a diminishing marginal return on education. The rest depends on other equally important, or even more important, factors. Therefore, it is impossible to conclude that education caused good decision-making.

The conclusion

In the earlier part of this paper, we established that people make decisions based on "judgements" and "intuitions" and they can be affected by many factors. Many of the factors that can affect "judgements" and "intuitions" are psychological. Then, we asked: How effective is education in changing the quality of decisions?

From the empirical evidence, we can see that financial literacy is not common among the general public, especially among people who are retired or approaching retirement, women people with low level of education, and certain racial groups. We can also see that financial literacy promotes positive financial behavior, e.g. retirement planning and participation in the stock market. Furthermore, empirical evidence also found statically significant association between financial education and financial literacy. Ultimately, we can conclude that there is a positive link between financial education and financial decision-making. In the later part of this paper, we explained that there is not enough material to determine the causality between education behavior.

The high degree of involvement in the financial market today means people have to make more financial decisions And because the stakes are high, i.e. their retirement, it is very important for people to make sound financial decisions. Or as Lusardi put is: "[I]t is very hard to live and operate efficiently today without being financially literate" (Financial Literacy 16). In this paper, we have examined the connection between education and its effect on decision-making. The conclusion from this is that financial education can boost financial literacy and ultimately leads to better financial decision-making, however, causality cannot be determined.

Works Cited

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"Education." Def. Merriam-Webster Online Dictionary. Web. 10 Mar 2010 <>

Gladwell, Malcolm. Outliers: The Story of Success New York: Little, brown and Company, 2008.

Knight, Frank H., Risk, Uncertainty, and Profit. 1921. Library of Economics and Liberty. 23 March 2010. <>.

Khatri, Naresh, Ng, H. Alvin. "Role of Intuition in Strategic Decision Making" 1997.

Kiviat, Barbara. "How to Teach kids About Money." Time Online. 25 Jan. 2010. Web. 7 Mar. 2010 <,9171,1953695,00.html>.

Lusardi, Annamaria. "Financial Literacy: An Essential Tool for Informed Consumer Choice?" Jun. 2008. NBER Working Paper No. W14084.

--- "Saving and the Effectiveness of Financial Education." Pension Design and Structure: New Lessons from Behavioral Finance. Ed. Mitchell, O. Utikus, S. Oxford University Press, 2005.

Ruffenach, Glenn. "Confessions of a Scam Artist." Wall Street Journal 9 Aug. 2004: R1.

Shiller, R. "Bubbles, Human Judgement and Expert Opinion." Cowles Foundation Discussion Paper, NO 1303. 2001 <>.