Clues for the Clueless

It is, or at least it should be, a simple question. You have $200 in an investment that's earning 10 percent a year. Assuming you let the money grow, how much would you have at the end of two years? If you answered $240, you've got plenty of company: in a 2004 survey of American adults, 34 percent gave that answer, which is incorrect, since it ignores the principle of compound interest. In fact, that $200 investment would earn $20 during year one and $22 in year two (on the larger balance). That totals $242—which only 18 percent of adults answered correctly. (The rest gave even worse incorrect answers or copped out.) While it may seem like a trivial exercise, research shows that people who can answer questions like these do better at planning for retirement, saving and managing their debts.

As millions of Americans struggle with mortgage payments they can't afford, there's new interest in helping close this financial IQ gap. This week a group called the Jump$tart Coalition for Personal Financial Literacy will release its latest survey of how much high-school and college students know about money. In past surveys, students have scored abysmally low, and no one expects much improvement this year. But there is hope that the subprime-mortgage crisis may generate momentum for change. In January, President George W. Bush announced the creation of the President's Advisory Council on Financial Literacy—a group that, with luck, will have a greater impact on Americans' well-being than the President's Council on Physical Fitness. "It's going to be a very teachable moment," says Ted Beck, president of the National Endowment for Financial Education.

Financial pros have fretted for decades over our ignorance about money. It's not that Americans' financial knowledge has declined, but that the need for it has increased. Until 30 years ago, people shopped mostly with cash, relied on company pensions for retirement and bought houses using fixed-rate mortgages. Today's world of credit cards, 401(k)s and exotic mortgages require more-sophisticated consumers, but there are few mechanisms to aid this transformation. Some high schools offer courses that teach students how to balance a checkbook or follow the stock market, but only 18 states require personal-finance instruction, and some principals resist adding the topic to schedules already crowded with really useful classes, like trigonometry. As a result, plenty of college graduates can psychoanalyze Hamlet and quote from the U.S. Constitution, but they don't know how an annuity works. "Even among highly educated people, a good proportion aren't financially literate," says Dartmouth economist Annamaria Lusardi.

Lack of education isn't the only factor—many of the roadblocks are psychological. Consider two basic items on most adults' to-do list: writing a will and buying life insurance. Both those activities require contemplating death, which we'd just as soon avoid. Financial decisions can also intimidate people because they often involve tangling with a commissioned salesperson. When cancer patients are deciding between chemo or radiation, they presumably can place more trust in a doctor than people choosing between a fixed-rate and adjustable-rate mortgage can place on their mortgage broker. Finally, when it comes to investing, behavioral economists put part of the blame on "loss aversion." That describes how the average person suffers more pain when losing $10 than pleasure from gaining the same amount; the phenomenon explains people's unwillingness to take risks. Since most investments that belong in retirement accounts (like stocks and mutual funds) decline in value at times, the possibility of loss scares some folks into staying on the sideline and making no choice at all.

Class and culture also play a role in financial-phobia. When Laureen Hudson, a 39-year-old technical editor, ponders why so many of her friends are clueless about money, she recalls how her crowd of left-leaning humanities and science majors held particular disdain for business students, who always had their noses in The Wall Street Journal. "It's considered noble to ignore money, and it's considered grubby or lesser to concern yourself with finance," she says. Noble or not, as an adult she's overcome that attitude; today she reads financial blogs, and she doesn't sign anything without asking tons of questions.

So far, the President's Advisory Council on Financial Literacy has held just a single meeting. As its work progresses, the result will likely be an array of new personal-finance tutorials—at schools, in workplaces and for people on the brink of big decisions, like buying their first home. While that's a good thing, consumers will also be better served if legislators and regulators continue taking steps to simplify the ways in which Americans save, borrow and invest. Instead of waiting for employees to sign up for a 401(k) on their own, some companies now opt for automatic enrollment and default investment choices. Likewise, as reformers scrutinize the mortgage industry, brokers may be held to higher standards, and closing documents may become more comprehensible.