Instead of prescribing specific financial advice, financial education efforts arguably should focus on providing information to enhance the ability of individuals to evaluate their own options, particularly for life's major financial decisions.
Last updated May 18, 2015
• Recently, the emphasis of many financial education efforts has broadened from improving financial knowledge to actively changing financial decision-making behavior.
• However, when designing policy and programs aimed at changing behavior, practitioners should be cautious in assuming that particular financial decisions constitute mistakes for all individuals.
• Furthermore, the cost of making a mistake may vary significantly by decision, with costs relatively low for routine decisions but potentially very high for major decisions that are infrequent, complex, and consequential over the long term.
• In the Richmond Fed's view, financial education efforts are best focused on providing high-quality information that helps individuals evaluate choices for major financial decisions in the context of their own unique circumstances.
• Such an approach likely gives financial educators and policymakers the best chances to enable households to improve their well-being with the lowest risk of unintended consequences.
Financial literacy is the ability of individuals to understand the obligations and potential payoffs of the financial decisions they make. To that end, financial education efforts take many forms, from teaching basic personal finance concepts, such as credit, to more in-depth instruction on specific financial decisions, such as purchasing a home or planning for retirement. Many school systems offer or require some type of personal finance instruction for students (see Council for Economic Education's Survey of the States). In addition, numerous organizations offer financial education for youth and adults, including the national Council for Economic Education and affiliated state councils, national and state Jump$tart coalitions, financial institutions, government institutions, and many others.
Financial education programs have traditionally been focused on improving financial knowledge, that is improving understanding of personal finance concepts and financial product options. More recently, the focus of financial education efforts has included changing financial behavior. This is reflected in the emphasis on the notion of "financial capability" now used by various institutions offering financial education (Sledge, Tescher, and Gordon 2010; see also FINRA Investor Education Foundation's National Financial Capability Study). With increased attention to financial capability and a focus on specific outcomes, financial education practitioners and policymakers may be tempted to steer people away from choices that might be considered mistakes. But there are few financial choices that are mistakes for all individuals. Instead of prescribing specific financial advice, financial education efforts arguably should focus on providing information to enhance the ability of individuals to evaluate their own options, particularly for life's major financial decisions.
What Is a Mistake?
A mistake is the selection of a particular choice when an unambiguously superior one, given the information accessible at the time, is available. However, it is extremely difficult for an outside observer to determine when an individual has made a mistake. As a result, one should be cautious in assuming that particular actions constitute financial mistakes for all individuals.
From a policy perspective, this is important because many people feel strongly that certain financial choices are always mistakes (for instance, taking out a very high-interest and often short-term loan). This has resulted in a desire among some policymakers and financial educators to limit the set of financial choices available to people. Before taking such action, it is crucial to recognize that what may appear to be a mistake to an outside observer may, in fact, be a sensible decision for the person making that choice. Consider a person with little or no savings who takes out a high-interest loan to fix his car. It may be tempting to dissuade him from making this "mistake." However, if he needs the car to get to work and also maintain his employer-provided health coverage, then the returns of the transaction may exceed its costs (Athreya and Stilwell 2009).
Therefore, limiting choices may result in a net loss in the decision-maker's well-being. This is part of what makes financial education challenging. Rather than focusing efforts on how to help people avoid pre-defined mistakes, financial literacy efforts arguably should be focused on improving people's ability to evaluate financial choices in the context of their individual circumstances. Evaluating a set of choices should be based on the preferences and constraints of the individual who is making the decision, instead of on the beliefs of the financial education provider or other observer.
Which Financial Decisions May Warrant the Most Attention?
The above is not to suggest that individuals never make financial mistakes or that there is no scope for them to improve their financial decision-making. However, not all mistakes are created equal. The cost of making a mistake or an uninformed choice is higher for some decisions than others, which has implications for where to focus financial education efforts.
Most financial decisions are routine and have only limited effects on long-term well-being. For example, although people may make mistakes (that is, suboptimal choices) in the order in which they pay off credit balances with varying interest rates, there are generally many opportunities to practice and learn from such mistakes. Moreover, the consequences of those decisions are relatively limited. By contrast, some decisions carry major consequences, such as whether to pursue higher education, whether to purchase a home and, if so, on what terms, and how to best save for retirement (Lacker 2009b). The Richmond Fed's financial education approach is focused on these "major" financial decisions because they have certain characteristics that differentiate them from other, more routine decisions that are likely to have smaller consequences for individual welfare. The distinguishing characteristics of a major financial decision include the infrequency of the decision, its complexity, and its long-term impact on the decision-maker's well-being (Lacker 2013a).
Infrequency, Complexity, and Long-Term Consequences
Major financial decisions are infrequent over an individual's lifetime. Therefore, there are few opportunities to practice, which raises the risk associated with the decision. For instance, it's not every day that a person retires. One's financial position at retirement depends on a multitude of projections and related choices over many years. But, for the most part, the consequences of the decisions over time are not fully realized until retirement, and at that point there is no opportunity to make different choices. The lack of practice making major decisions is further compounded for individuals who have limited opportunities to learn from others' financial decisions.
Major financial decisions are also complex. A household's evaluation of whether it is better off buying or renting a home is a complicated analysis that must take into account interest rates, changes in home prices, and a host of other economic and personal variables, such as how tied one is to a geographic area. Then, if a household decides that purchasing a home is the right decision, the complexities of comparing mortgage options and understanding mortgage contracts loom large.
Finally, major financial decisions tend to have lasting impacts on an individual’s welfare. The long-term consequences of these decisions stem from both their financial significance and from the fact that they are relatively illiquid and irreversible (Lacker 2013b). Consider the decision to pursue higher education. After a significant investment, and one that frequently requires substantial debt, the full returns from higher education are not immediately realized at graduation but rather over the course of a lifetime (see Our Perspective: Workforce Development). Unlike other assets that pay off over time, the knowledge and skills, or "human capital," acquired cannot be sold to someone else in return for a payment if the individual needs funds in the interim. With decisions like these, much is at stake for the decision-maker's long-term well-being.
Evaluating Financial Choices
Given the infrequency, complexity, and long-term implications of major financial decisions, individuals may find their choices quite difficult to evaluate. Individuals need reliable, unbiased information and tools to evaluate their choices, but that may not be enough. Studies have shown that individuals need certain foundational skills and an understanding of key financial concepts as well. In particular, evidence suggests that numeracy skills are critical to financial literacy, as is an understanding of basic concepts such as interest rates and compounding (Lusardi 2012). Without developing foundational skills and an understanding of key concepts, financial education efforts around major decisions are likely to be less successful. The Richmond Fed focuses many of its education efforts on developing economic and financial education resources and programs for teachers and students to aid in the early development of such knowledge and skills (see our Education page).
Being able to evaluate choices effectively is not simply a function of financial literacy, however; economic literacy is also key. Though the three major decisions discussed above are financial in nature, fundamental economic principles are at their core (Lacker 2009a). For example, the potential payoff from pursuing higher education is ultimately about human capital investment and productivity. Furthermore, it would be difficult for an individual to evaluate the choice between renting versus buying a home without understanding the principle of opportunity cost, or to evaluate retirement saving options without understanding the difference in risk between picking individual stocks and investing in broad stock index funds. In the Richmond Fed's view, financial education and economic education are closely intertwined, and financial education efforts should be based in economic principles.
The Interconnectedness of Choices
Perhaps the most important consideration for financial education efforts is that individual circumstances matter. Not only do individual circumstances make it difficult to label certain choices as mistakes, but each individual evaluates choices for their decisions in the context of their choices for other decisions. In other words, an individual's financial decisions are interconnected and not made in isolation. Therefore, failure to consider the full range of individual circumstances can result in education or policy that does not meet the specific needs of the individual or that leads to costly unintended consequences.
Consider an example related to housing. It may be tempting to implement policy or provide advice that encourages households to build wealth through mortgage-financed investments in housing. However, as a single asset, housing may be an investment with volatile returns (see Our Perspective: Housing Finance Policy). For a household that holds a small share of its wealth in other relatively stable assets, the blow to its overall wealth from a fall in the price of its house is likely to be large because of the lack of a buffer provided by other assets in the portfolio. Therefore, to fully assess the risk of buying a house, one needs generally to know more about the individual doing the buying.
As another example, consider financial education efforts that encourage investments with a sharp early withdrawal penalty, such as individual retirement savings. The penalties make the account less liquid, because the account holder cannot access the funds whenever she needs without cost. All else equal, the further the individual is from retirement, the more likely she will need access to liquidity at some point, for example, to pay for an unexpected large expense. If it is very costly for her to tap into her savings, she may be more likely to take out a loan to cover her expenses. In this case, a byproduct of a policy that encourages illiquid savings is a growth in debt. Still, the growth in debt might be reflective of a perfectly sensible decision of an individual given her needs and constraints.
Because of differences in individual portfolios and circumstances, a policy intervention or advice that targets a particular asset, like retirement savings, is likely to have different effects and perhaps unintended consequences for different people. This is an important point for policymakers and financial educators to consider when designing policy and programs that intervene in people's financial decision-making.
To truly improve an individual’s well-being, financial education efforts must be able to accommodate a variety of individually specific factors, including the preferences of the decision-makers. As a consequence of the difficulties in gleaning all relevant information that might influence any given financial decision, our view is that it is generally best to avoid prescriptive financial guidance and to refrain from flatly restricting the range of choices available to individuals in an effort to protect them from making pre-defined mistakes. Rather, the most beneficial approach is likely to be one focused on helping people make the best decision for themselves by providing them with high-quality information, recognizing that in some instances these decisions will not be what we might choose for ourselves. Moreover, we believe this information should be focused on helping households better evaluate their choices for infrequent, complex, long-term financial decisions, which can have large and long-lasting consequences for their well-being.
Lastly, we should note that we have said little about assessing the effects of financial education. Rigorous research on the efficacy of financial education programs is young, and it is difficult to measure the effects of particular educational interventions on financial decision-making (Martin 2007). Still, theory and evidence suggest that financial education programs are likely to be most effective when they take into account people's unique needs (Lusardi and Mitchell 2014).
In summary, we advocate an approach to financial education that provides high-quality, unbiased information that is closely informed by fundamental economic principles. We recognize that adherence to such an approach will be generally, though not always, less amenable to providing specific advice. Nonetheless, we believe such an approach will give financial educators and policymakers the best chances to enable households to increase financial capability with the lowest risk of unintended consequences.
Richmond Fed References
Athreya, Kartik, and Anne Stilwell. "Rationalizing Financial Literacy Policy." Federal Reserve Bank of Richmond Economic Brief No. 09-03, March 2009.
Federal Reserve Bank of Richmond. "Our Perspective: Housing Finance Policy."
Federal Reserve Bank of Richmond. "Our Perspective: Workforce Development."
Lacker, Jeffrey M. "Financial Education in the Wake of the Crisis." Speech to the 2009 Council for Economic Education Annual Conference, Washington, D.C., October 8, 2009a.
Lacker, Jeffrey M. "The Importance of Financial Education." Federal Reserve Bank of Richmond Region Focus, Fall 2009b, vol. 13, no. 4, p. 1.
Lacker, Jeffrey M. "Human Capital Investment as a Major Financial Decision." Speech to the 2013 Council for Economic Education Annual Conference, Baltimore, Md., October 4, 2013b.
Martin, Matthew. "A Literature Review on the Effectiveness of Financial Education." Federal Reserve Bank of Richmond Working Paper No. 07-03, June 2007.
Council for Economic Education. "Survey of the States: Economic and Personal Finance Education in our Nation's Schools," 2014.
Financial Industry Regulatory Authority (FINRA) Investor Education Foundation. "National Financial Capability Study," 2014.
Lacker, Jeffrey M. "Focusing on Major Financial Decisions." Blog post for the Council for Economic Education, April 2, 2013a.
Lusardi, Annamaria. "Numeracy, Financial Literacy, and Financial Decision-Making." Numeracy, 2012, vol. 5, no. 1, article 2.
Lusardi, Annamaria, and Olivia S. Mitchell. "The Economic Importance of Financial Literacy: Theory and Evidence." Journal of Economic Literature, March 2014, vol. 52, no. 1, pp. 5-44.
Sledge, Joshua, Jennifer Tescher, and Sarah Gordon. "From Financial Education to Financial Capability: Opportunities for Innovation." Center for Financial Services Innovation, 2010.
Athreya, Kartik B., and David A. Price. "Implications of Risks and Rewards in College Decisions." Federal Reserve Bank of Richmond Economic Brief No. 13-06, June 2013.
Athreya, Kartik B., Felicia Ionescu, and Urvi Neelakantan. "Stock Market Participation: The Role of Human Capital." Federal Reserve Bank of Richmond Working Paper No. 15-07R, Revised June 2016.
Higher Education: Are You Ready for the Next Frontier? Federal Reserve Bank of Richmond 5E Navigator.
Invest in What's Next: Life After High School
An interactive, online resource to help high school students navigate their first major financial decision — what path to pursue after high school
Lacker, Jeffrey M. "Life After High School." Blog post for the Council for Economic Education, April 11, 2014.
Lacker, Jeffrey M. "Financial Learning is a Lifelong Process." Federal Reserve Bank of Richmond Econ Focus, Third Quarter 2014, p. 1.
Major Financial Decisions
A resource website to help answer important financial planning decisions related to choosing an education and career path for life after high school, whether to buy or rent a home, and how to plan for retirement
Research Focus: Consumer Finance
A full list of research papers and articles related to consumer finance from Richmond Fed economists
Sablik, Tim. "Investing over the Life Cycle: One Size Doesn’t Fit All." Federal Reserve Bank of Richmond Economic Brief No. 14-10, October 2014.
Student Loans: Are Yours Afloat? Federal Reserve Bank of Richmond 5E Navigator.
Weinberg, John A. "A Focused Approach to Financial Literacy." Federal Reserve Bank of Richmond Region Focus, Third Quarter 2011, p. 56.