Chances are, you sweat over how to pay the bills, keep a roof over your head and maybe set aside a few bucks for a retirement that seems to recede further in the distance with every birthday you celebrate. While you've been going about your life, a small army of economists and behavioral researchers have been studying what you do and don't do, what you know about finances and how you make important money decisions.
Foremost among them are academics Annamaria Lusardi at the George Washington University School of Business and Olivia S. Mitchell at the University of Pennsylvania's Wharton School. Frequently doing joint research projects, the two have amassed an enormous body of work about the level of consumer financial literacy, which is generally abysmal, its consequences and what we should do about it.
Their findings are important to consumers for two powerful reasons: First, if people understand exactly what their poor decisions cost them, perhaps they'll do something about it, and second, the experts' views on consumer behavior increasingly wind up turned into a law that forces consumers to do certain things because they're deemed not capable of making good decisions on their own. Welcome to the world of behavioral economics.
In a recent paper for the National Bureau of Economic Research, Lusardi and Mitchell reviewed the growing research evidence of how low levels of consumer financial literacy lead to money-losing decisions. Here is a "hit parade" of sorts of how we shortchange ourselves:
1. Those who are more financially literate are also more likely to undertake retirement planning, and those who plan also accumulate more wealth.
2. More financially literate individuals are more likely to choose pension accounts with lower administrative fees.
3. More financially sophisticated individuals are less affected by the choices of peers in their financial decisions.
4. Even just learning about the concept of compound interest produces a sizeable increase in pension contributions.
5. Those with lower incomes and less education (characteristics strongly related to financial illiteracy) are less likely to refinance their mortgages during a period of falling interest rates. The cost of such inaction is $50 billion to $100 billion a year in higher mortgage interest payments.
6. Those unable to correctly calculate interest rates end up borrowing more and accumulating less wealth.
7. The least financially savvy incur high transaction costs, more for products, services and related fees.
8. The least literate are also more likely to borrow against their 401(k) and pension accounts.
9. Those who are less financially literate are substantially more likely to use high-cost methods of borrowing, such as payday loans, pawn shops, auto title loans, refund anticipation loans, and rent-to-own shops.
10. Financial literacy can explain more than half the wealth inequality observed in U.S. data.
11. In a Dutch study, being in the 75th versus the 25th percentile of a financial literacy index was equal to about 3.5 times the annual net disposable income of a median Dutch household.
12. The least financially literate are more likely to pay higher investment fees and expenses.
13. Of course, the least financially literate also left the stock market and have stayed away, costing them about 4 percent of their wealth as market values recovered from the recession.
14. Failing to have a diversified investment portfolio costs financially inexperienced investors a substantial amount of investment income.
15. The average credit-card fees paid by those with low knowledge are 50 percent higher than those paid by the average cardholder.
The decision-making landscape to prepare for retirement is particularly challenging, according to Lusardi and Mitchell. "Retirees must look ahead to a future of uncertainty when making irrevocable choices with far-reaching consequences. For instance, people must forecast their (and their partner's) survival probabilities, investment returns, pension income, and medical and other expenditures," they write.
"Moreover, many of these financial decisions are once-in-a-lifetime events, including when to retire and claim one's pension and Social Security benefits," they note in their paper. "Accordingly, it would not be surprising if financial literacy enhanced peoples' ability to make these important decisions later in life."
While there have been gains in school-based financial literacy courses, research findings give broad-based educational efforts low marks. To be effective, financial education must be targeted to the precise needs of those being taught. And it should go into some detail about personal finance as well.
It is tempting to say that financial literacy is generated by personal needs. A high-earning individual who wants to invest in the stock market is more likely to learn about investing than a lower-income person with no funds to invest. However, the two economists say, financial literacy also improves outcomes in its own right. "The causality goes from knowledge to behavior," they write.
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