I Was Told There Would Be No Math

MathIn a 2009 NBC/Wall Street Journal poll, 8 in 10 Americans said they were concerned about the federal deficit and growing national debt.

But a separate poll that same year asked, "How many millions are in a trillion?" and 79% of Americans either answered wrong or didn't know.

Think about that. Eight in 10 Americans are worried about the national debt, but the same number can't accurately put the numbers into context. How do you know if $15 trillion of debt is dangerous if you don't know what a trillion is?

Deficits are something to be concerned about. But a bigger threat to your personal finances exists: innumeracy.

In a recent paper titled "Numeracy, Financial Literacy, and Financial Decision-Making," Dartmouth economist Annamaria Lusardi came to a shocking conclusion: Most young baby boomers about to enter retirement struggle with basic, real-life financial arithmetic. And those who need the most financial knowledge tend to be the most innumerate.

Here's an example:

"Let's say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?"

Take your time. Feel free to use a calculator. What's your answer?

When asked, 82.2% of those age 51 to 56 couldn't produce the right answer ($242). Of those who answered wrong, about half erred by ignoring that interest accrues on both principal and interest -- compound interest.

That was one example of many. Given three basic questions on interest, division, and percentages, only a small fraction of those about to enter retirement could answer all correctly.

"These are pretty dismal findings, considering the complexities of the calculations involved in many financial decisions," Lusardi writes.

Dismal and scary. In 1979, 38% of private-sector workers were covered by an employer-provided pension plan that required minimal planning on their part. By 2008, just 15% were. At the same time, defined-contribution plans like 401(k)s that require workers to plan and manage their own funds ballooned, covering 43% of workers in 2008 from 17% in 1979, according to the Employee Benefit Research Institute. Unlike the past half-century, Americans' "retirement security will depend ever more on their own decisions" going forward, Lusardi writes. And yet look at where we are. Too many Americans still rely on a famous quote from the movie Reality Bites: I was told there would be no math.

But what's fascinating about all of this is that the standard response -- that we need more financial education and more emphasis on financial literacy -- may not be the complete answer. Lauren Willis at Loyola Law School has shown (link opens PDF) that financial-literacy programs can actually be harmful to people's financial wellbeing. How? For some, it increases confidence without improving ability. You can imagine someone taking a one-day class on derivatives trading and suddenly thinking they're George Soros, only to watch their portfolio disintegrate through hyperactive and ill-informed trades. That's an extreme example, but it captures how people actually behave. Put simply, there is "no reliable empirical evidence that financial-literacy programs are effective," Willis writes.

The key to getting people to make smarter choices with their money, then, may not be financial literacy or numeracy in itself. It's combing literacy with a proper understanding of the softer sides of financial knowledge -- things like behavioral finance, psychology, and emotional intelligence. Widespread innumeracy is a sign that financial education is lacking. But it's the emotions of finance that really influences how people manage their money.

Take a well-known example. In 1998, the hedge fund Long Term Capital Management, staffed thick with Ph.D.s and two Nobel laureates, exploded under an almost incomprehensible amount of leverage. Behind the failure was management's utter lack of emotional control. "The young geniuses from academe felt they could do no wrong," wrote Roger Lowenstein in the book When Genius Failed.

Warren Buffett later said this about the firm's 16-person management team:

"They probably have as high an average IQ as any sixteen people working together in one business in the country ... just an incredible amount of intellect in that group. Now you combine that with the fact that those sixteen had extensive experience in the field they were operating in ... in aggregate, the sixteen probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worths in the business. ... And essentially they went broke. That to me is absolutely fascinating."

The managers of LTCM had higher financial literacy and were more numerate than almost anyone on the planet. And they literally went bankrupt.

On the contrary, three years ago I interviewed hedge fund manager Mohnish Pabrai, whose track record puts him among the top money managers of the past decade. Pabrai doesn't use analyst teams. He doesn't use complex spreadsheets. There are no Bloomberg terminals in his office. I'd be surprised if he owns a calculator. When I asked him what his edge was, he replied, "Control over my emotions." That's it? I asked. "It's huge. You'd be surprised."

Pabrai understands finance, of course. He's quite numerate. But it's the emotional intelligence he applies to that knowledge that allows him to make smart financial decisions while so many others make mistake after mistake. That speaks volumes about what a useful financial education should include.

So what's the solution? We do need more financial education that teaches basic numeracy, but that education should first and foremost teach the emotional constraints of finance. After all, it doesn't help to know what APR is unless also taught that bankers selling loans rarely have your best interest at heart. Knowing how to read a balance sheet doesn't help unless you also appreciate the biases that cause investors to buy high and sell low. And understanding compound interest won't help without conquering the social pressures that prevent people from saving money in the first place. We must focus on fixing America's innumeracy. But it's like Aristotle said: Intelligence without wisdom is worthless.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

At the time this article was published

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Investing Like Warren Buffett

Learn from one of the world's best investors.

View Course »

Introduction to ETFs

The basics of Exchange Traded Funds and why ETFs are hot.

View Course »

Add a Comment

*0 / 3000 Character Maximum

82 Comments

Filter by:
Damian

Great article! ....and a true gift from God for me. Thank you. I am sure you don't see it that way. That's ok. Just another example for me.

My financial literacy is very low right now and we all want freedom to live life and enjoy what's been afforded to us. Learning about my emotional maturity, my ability to not make unreasonably emotional decisions that are going to hurt me or hurt my family needs to be a constant reminder.


Again, very impressed with your ability to write concisely and deliver a good message.

A gift I don't have....and am not motivated enough at this time to try to develop.

for the other posters..."he's keeping it simple for a broad audience"

especially those of us with low financial IQ's which as evidenced in his article is a LARGE MAJORITY....I may have a low financial IQ, but I I have enough math IQ to understand what a large majority means and how it's a really well done job in his article.

There is no wonder people, really intelligent people make horrificly un-wise mistakes. They are in the wrong forest or they don't open their ears to hear what the author is saying. The question should be "Do I get the point of this article?"

There is a reason sports teams that should obliterate their lessor opponents 10 out of 10 times yet never really come close to that number. see K-State vs Oklahoma college football Big 12 championship 2003-2004. Much like the referenced hedge fund(I don't really understand what these are) group that should by all standards been a can't miss and it sounds like they fell on their collective asses.

I love life and the gift it is!

Rock on Morgan and thank you.

February 23 2012 at 10:07 AM Report abuse rate up rate down Reply
dazey1st

I could better get the idea of these millions, billions, and trillions if they were put into a material context. My math is non-existant. Like how many 1000 dollar bills (do they print $1000 bills? I've never had any so I don't know) would it take to make a billion if placed end to end , for example would they reach the moon and back or circle the planet? I can't relate to these sums of money, and worrying about it would damage my mental health. All I do know is how much money I have in my piggy bank and how to get at it.

February 22 2012 at 8:06 PM Report abuse rate up rate down Reply
Peanut Gallery

Baby boomers make up the voting and fiscal majority and just proved themselves to be mathematically illiterate.
How big is our deficit? $15 trillion? How big is the subprime scandal? $600 trillion? What is the gross world product? $70 trillion? This is why it's too easy for China to step in and take over.
Most of the people who took out subprime backed mortgages on speculative secondary $700,000 + equity loans they could not afford are upper middle class CAUCASIANs who are in the boomer age category- yet in the same breath they feel entitled to attack the non-entitled college student who had to take out a student loan so they can learn where their mistakes are. This country makes me ill.

February 22 2012 at 7:48 PM Report abuse rate up rate down Reply
Beautiful

let me put it this way, a million dollars is a lot of money and more than most have, a trillion is A LOT more than a million. if it ain't in my bank account, i can't spend it, if it's not in the gov't's bank account, why can they spend it?

February 22 2012 at 6:04 PM Report abuse +1 rate up rate down Reply
jcoxqb17

where can you get 10%

February 22 2012 at 5:37 PM Report abuse rate up rate down Reply
1 reply to jcoxqb17's comment
Peanut Gallery

Volcker would've given it to you. Too bad your elected politicians won't let him.

February 22 2012 at 7:41 PM Report abuse rate up rate down Reply
USYachting

At a thousand dollars per day, you would spend a million in less than three years. To spend a billion at the same rate, you'd need to have started a thousand years before Christ was born. To spend a trillion, you'd need to have started about 3 million BC. As an American, each trillion the government spends takes about $3,000 out of the pocket of every man, woman and child.

February 22 2012 at 5:27 PM Report abuse rate up rate down Reply
USYachting

At a thousand dollars per day, you would spend a million in less than three years. To spend a billion at the same rate, you'd need to have started a thousand years before Christ was born. To spend a trillion, you'd need to have started about 3 million BC. As an American, each trillion the government spends takes about $3,000 out of the pocket of every man, woman and child.

February 22 2012 at 5:26 PM Report abuse rate up rate down Reply
Ian

Why is the correct answer $242? Compound interest was mentioned but never calculated. Even simple interest would net more then the $242.

February 22 2012 at 4:32 PM Report abuse rate up rate down Reply
2 replies to Ian's comment
tz1030

First year : $200 + $20 (10% of the 200) so at end of year 1 you have 220.
Second year $220 + $22 (10% of the 220) so at end of year 2 you have 242.
(Math nerd at work)

February 22 2012 at 4:42 PM Report abuse rate up rate down Reply
tz1030

Year 1: $200 + $20 (10% of 200) so at end of year 1 you have 220.
Year 2: $220 + $2(10% of 220) so at end of year 2 you have 242

February 22 2012 at 4:43 PM Report abuse rate up rate down Reply
allergical

"Let's say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?"

I'd have a couple of hundred thousand in it, cause if its paying 10% a year for an insured deposit, I'm moving the rest of my money in!

February 22 2012 at 4:24 PM Report abuse rate up rate down Reply
allergical

"Let's say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?"

I'd have a couple of hundred thousand in it, cause if its paying 10% a year for an insured deposit, I'm moving the rest of my money in!

February 22 2012 at 4:24 PM Report abuse rate up rate down Reply