Is Financial Knowledge Key to Successful Investing?

The public doesn’t know how to manage their finances, that’s according to a study commissioned by the US SEC.

From the Wall Street Journal Blog,

Good news for those intent on committing fraud. Bad news for most everyone else. American investors apparently don’t know much about anything financial.

According to a review released Thursday of years of surveys of individual investors, they are presumably ripe for the picking by fraudsters because they don’t have much knowledge to counteract any outlandish offerings.

Here’s the key and rather astonishing 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…”

That is from the Library of Congress, which conducted the review on behalf of the Securities and Exchange Commission. The SEC, for its part, needed to study Americans’ financial literacy and assess what investors wanted to know about investments and advisers and how they wanted to receive the information. The SEC had a mandate for all that from the 2010 Dodd-Frank Act.

This generalized lack of knowledge (there certainly are plenty of exceptions) is particularly worrisome since more and more people are responsible for their own investment decisions as part of defined-contribution retirement plans, usually 401(k)s.

The Library of Congress said: “If employees do not have the requisite knowledge, they will not be prepared to make informed decisions regarding the management of their financial affairs, including investing for a secure retirement.”

The public (not limited to Americans) may not be technically sophisticated in the realm of finances but to claim that they are “not be prepared to make informed decisions regarding the management of their financial affairs” looks outrageously untrue.

This misleading assertion presupposes that government should play a role to compel people to get educated "financially".

In reality, America’s standard of living has been higher than most of the world because of capital accumulation.

As the great Ludwig von Mises wrote,

The average standard of living is in this country higher than in any other country of the world, not because the American statesmen and politicians are superior to the foreign statesmen and politicians, but because the per-head quota of capital invested is in America higher than in other countries. Average output per man-hour is in this country higher than in other countries, whether England or India, because the American plants are equipped with more efficient tools and machines. Capital is more plentiful in America than it is in other countries because up to now the institutions and laws of the United States put fewer obstacles in the way of big-scale capital accumulation than did those foreign countries.

Americans not only knew but appropriately acted to manage their state of affairs through the productive balancing of savings and investments which resulted to such high levels of capital accumulation

Moreover, having financial knowledge does not necessarily translate to having the expertise for “investing for a secure retirement”

In reality, financial knowhow does not make one infallible from loses.

In debunking the idea that financial success comes out of high IQs, I recently wrote,

The landmark bankruptcy by Long Term Capital Management in 1998 had been a company headed by 2 Nobel Prize winners. The company’s failure has substantially been due to flawed trading models.

In 2008, the 5 largest US investment banks vanished. These companies had an army of economists, statisticians and quant modelers, accountants, lawyers and all sort of experts who we assume, because of their stratospheric salaries and perquisites, had high IQs.

When Queen Elizabeth asked why ‘no one foresaw’ the crisis coming, the reply by the London School of Economics (LSE)

"In summary, Your Majesty," they conclude, "the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole."

Imagination had been scarce because the same army of experts heavily relied on mathematical models in dealing with investments. They did not follow the common sense advise by the real experts.

These people had all the supposed “expertise” yet they all burned investor's money.

The failure of pseudo financial mastery explodes the idea that “generalized lack of knowledge” will not enable people “to make informed decisions”.

To add, if one looks at the list of the victims of fraud committed by scam artist Bernie Madoff, they had hardly been about financial ignorance

Again I wrote,

Thus, it is no different when Bernard Madoff bamboozled $50 billion off from the who’s who list which includes top rated financial institutions among them banks, (e.g. BNP Paribas,Banco Santander, Fortis Bank Netherlands, HSBC Holdings, Nomura Holdings, Royal Bank of Scotland and etc.) insurers (CNP Assurances, Clal Insurance, Harel Insurance) and Hedge funds (Tremont Group Holdings, Fairfield Greenwich).

To consider, these institutions account for as supposedly smart money outfits since they are backed by an army of “elite professionals”, e.g. economists, accountants, risk managers, quants etc…). Yet at the end of the day, smart money seemed like everybody else; they got what they deserved because they substituted prudence with fad

In reality, inflationist “bubble” policies, which obscures price signals and whets the speculative or gambling appetite, have been the principal influence to fraud.

As a side note: even the most successful stock market investor Warren Buffett admits of occasional investing mistakes.

In Manias, Panics and Crashes Charles Kindleberger’s insight has been highly relevant, (I quoted from my previous article)

Commercial and financial crisis are intimately bound up with transactions that overstep the confines of law and morality shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft embezzlement or fraud

Bottom line: having financial knowledge is necessary but not sufficient reason for securing financial success.

Relevant theory backed by quality information from the desire to profit (stakeholder's dilemma) has to be used as framework for such analysis.

Morris Cohen in his 1944 book, A Preface to Logic provides a useful insight (quoted by Professor Don Boudreaux)

There can be no doubt that statistics deals with actuality, and that knowledge of actualities is always empirical, i.e., that we cannot obtain knowledge by purely a priori methods. There is, however, no genuine progress in scientific insight through the Baconian method of accumulating empirical facts without hypotheses or anticipation of nature. Without some guiding idea we do not know what facts to gather. Without something to prove, we cannot determine what is relevant and what is irrelevant.

And this should be complimented by emotional intelligence and self-discipline.