Financial Illiteracy Found in Study of Financial Literacy

“Understanding the needs of investors is critical to carrying out the Commission’s investor protection mission,” said SEC Chairman Mary L. Schapiro. Section 917 of Dodd-Frank required the SEC to study the existing level of financial literacy among retail investors. The study was recently released and paints an ugly picture.

Here’s a key quote:

These studies have consistently found that American investors do not understand the most basic financial concepts, such as the time value of money, compound interest and inflation. Investors also lack essential knowledge about more sophisticated concepts, such as the meaning of stocks and bonds; the role of interest rates in the pricing of securities; the function of the stock market; and the value of portfolio diversification…

Perhaps a few decades ago this was less of a problem when big unions were at their most powerful position and big businesses were offering pensions to retirees. With the rapid decline in pensions in favor of 401(k)s and other defined contribution plans, more and more people are responsible for their own investment decisions. It seems they do not have the skills or literacy to do so.

What to do? Neal Lipschutz suggests:

Here’s a modest suggestion: make passing a course in the basics of personal finance a requirement for a high school diploma. You can teach about credit cards, checking accounts, mutual funds and the like. You might even throw in how to vet an investment adviser.

I expect this problem will soon get worse. Private funds will soon be able to start advertising. That means investors that meet the minimal standard of accredited investor will be barraged with opportunities to invest in the once secretive world of hedge funds. That advertising will be limited by the false, misleading or deceptive standard of investment advisers, not by the more strict standards for mutual funds under the Investment Company Act.

I suspect, as does Felix Salmon, that it will not be the excellent funds that advertise. It will be the those that want the flash of the media spotlight.

Private funds will not be held to a uniformity standard allowing potential investors to better compare fund to fund. They’ve gotten accustomed to the relative uniformity with the highly regulated mutual fund products.

It was very obvious that the SEC was not happy with the JOBS Act and is washing its hands of the problems by doing exactly what Congress demanded, and nothing more. At some point there will be a backlash and some additional legislation to deal with the problems that will inevitable arise. Good firms, doing the right thing will likely be subject to further oppressive regulation because of the unrestrained actions of a few bad actors.

Being an accredited investor just means that you have money, not that you understand how to invest your money. I suspect many more will start making bad investments as they hear the siren song of hedge funds.