Financial Literacy

There was an article in the New Yorker[i] recently titled “Greater Fools” by James Surowiecki about financial literacy in America.  All of us in the Personal Financial Planning department, as well as the Office for Financial Success and Missouri Council on Economic Education, are very passionate about financial literacy, so these types of articles tend to make their way into our inboxes.

We are always glad when we get these articles and feel good knowing that we are teaching students and community members to become financially literate.

While you can read the full article via the link below (and we encourage you to do so) here are a few excerpts from the column:

“The depth of our financial ignorance is startling. In recent years, Annamaria Lusardi, an economist at Dartmouth and the head of the Financial Literacy Center, has conducted extensive studies of what Americans know about finance. It’s depressing work. Almost half of those surveyed couldn’t answer two questions about inflation and interest rates correctly, and slightly more sophisticated topics baffle a majority of people. Many people don’t know the terms of their mortgage or the interest rate they’re paying. And, at a time when we’re borrowing more than ever, most Americans can’t explain what compound interest is.

“Financial illiteracy isn’t new, but the consequences have become more severe, because people now have to take so much responsibility for their financial lives.

“The government’s new consumer-protection agency has the authority to “review and streamline” financial literacy programs, but that’s not enough. We really need something more like a financial equivalent of drivers’ ed.”

While we are seeking to improve financial literacy, we realize there is still much work to be done.  Nan Morrison, President & CEO of the Council for Economic Education, has some follow-up thoughts to Surowieki’s article and some ideas for improvements and steps we can take:

“James Surowieki’s financial page piece “Greater Fools” unfortunately quite accurately diagnoses the depths of America’s struggle with financial literacy and its costs to society. And without significant changes, our children may face an even worse fate than their parents. Nellie Mae reports that on average, incoming freshmen now bring an average of $1,585 in credit card debt to college. 

“Yet despite the extent of this problem, according to a CEE / State Farm survey, only 21 states require an economics course to be taken in K-12, and only 13 states require a course in personal finance. Even fewer require testing of these concepts. But requirements need trained teachers, and to make matters worse, as a society, we are not preparing teachers to deliver this vital content with confidence.  In a recent survey by the National Endowment for Financial Education (NEFE), less than 20 percent of teachers reported feeling competent to teach basic personal finance topics. Furthermore, even many teachers of high school economics have taken two or fewer semesters of economics in college. 

“In our eyes, the real question is ‘How, as a society, can we improve our economic and financial literacy and what benefits might we see in future generations as a result?’

“Our answer at the Council for Economic Education (CEE) – equip and enable teachers to educate our children in basic personal finance and economic concepts in school from kindergarten through 12^th grade.  Why? Good habits are built early, just like brushing your teeth. 

“America is about economic opportunity – our kids need to be financially fit and economically literate to grasp that opportunity.  As consumers, investors, entrepreneurs, and voters we all make decisions that involve finance and economics every day.  If every parent, school and state, made economic and financial education a priority in schools from K-12, perhaps more Americans would be able to ensure their financial well being in a changing and complex world. Improving our collective economic and financial literacy is vital to our economic growth, job creation, and prosperity.  Many in government, education, and financial services, across our nation support those goals, as they are good business and good citizenship well as essential ingredients in a stable financial system.”

We will continue to train students and high school financial planning teachers in Missouri, but more needs to be done.  If you live in a state where financial education is not required we encourage you to contact your local legislators and share these types of articles with them.  Encourage them to require personal finance classes in schools. 

If you are a parent be sure that your children are not financially illiterate.  Even if your child is required to take a course in personal finance at school we encourage you to have discussions with them, at a very young age, about finances.  Help them open their first checking and savings accounts, teach them about interest (both paying and earning it), help them learn to balance their checkbooks, live on a budget, understand credit, etc.  Find out what they are learning in their financial classes and discuss it with them.

Together we can make a difference and hopefully reverse this growing trend of financial illiteracy.

Ryan H. Law, M.S., AFC

Department of Personal Financial Planning

Office for Financial Success Director

University of Missouri Center on Economic Education Director

 

239E Stanley Hall

University of Missouri

Columbia, MO 65211

 

573.882.9211

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[i] http://www.newyorker.com/talk/financial/2010/07/05/100705ta_talk_surowiecki

Is it a Wise Economic Decision to Purchase a Hybrid Car?

There are a lot of reasons to consider buying or leasing a hybrid car.  The obvious reason is environmental—hybrid drivers are committed to doing their part for the environment by driving a more fuel-efficient vehicle.  But as I was car shopping earlier this summer, I got to thinking: Is it a wise economic decision to purchase a hybrid car?

To answer this question, I first wanted to figure out the “hybrid premium.”  In other words, how much more expensive is a car because it is a hybrid?  The clearest way to answer this question is to compare the sticker price of standard models and their hybrid equivalents.  Here are a few examples.

	Toyota		Ford		Honda
Model	Camry (2011)	Camry Hybrid (2011)	Fusion (2011)	Fusion Hybrid (2011)	Civic (2010)	Civic Hybrid (2010)
MPG*	24	34	24	34	24	37
Base Price	$19,595	$26,400	$19,696	$28,100	$15,655	$23,800
Hybrid Premium	$6,805		$8,404		$8,145

 

*Miles per gallon are typically calculated for city vs. highway driving.  For simplicity’s sake, I am using the Consumer Reports “Overall MPG” for this calculation, which is an average based on a typical driver’s combined city and highway driving.

The average American owns a car 4-6 years.  So for the sake of argument, let’s assume that you plan to own your next car for seven years.  Let’s also assume that that you drive 12,000 miles per year, and the average price of gasoline over that period is $2.80 per gallon.  Will the amount of money you save on gas exceed the hybrid premium you are paying?  As the following table shows, the quick answer is “no.”

	Gas Savings – Hybrid Premium = Hybrid Cost Savings
Year	Camry	Fusion	Civic
1	-6,393	-7,992	-7,653
2	-5,981	-7,580	-7,161
3	-5,569	-7,168	-6,669
4	-5,157	-6,756	-6,177
5	-4,745	-6,344	-5,685
6	-4,333	-5,932	-5,193
7	-3,921	-5,520	-4,701

 

Since these hybrids save the consumer approximately $450/year in gasoline, at first glance the purchase of a hybrid is not a wise personal economic decision.  However, there are additional caveats to consider.  First, there are tax credit considerations.  If you are purchasing a vehicle (rather than leasing), you may be eligible for a tax credit of up to $3,400.  Additionally, if you are a high mileage driver (like me), your annual gasoline savings will be much higher than the average person who drives 12,000 miles per year.  Finally, the consumer rarely chooses between the standard model and hybrid model of the same vehicle.  So if you are choosing between a Prius and a Hummer, the hybrid gas savings calculation will look quite different.

Even when taking these additional points into account, it is still difficult to make an economic case for purchasing a hybrid over the equivalent non-hybrid model.  However, it is also important to recognize that most people make decisions that include harder to quantify “bundles of utility.”  Since a hybrid car makes people feel more socially conscious, and there is a utility to this feeling, a car purchase is about much more than dollars and cents.

By the way, I decided to lease a Honda Insight Hybrid.  I feel better about myself already.

Mike English
President & CEO
Missouri Council on Economic Education
englishmi@umkc.edu

 

To Amort or Not to Amort

Amort is defined as “lifeless” in my University owned edition of Webster’s Dictionary (circa 1958).  It is also the root word for amortize, defined in that dictionary as “the gradual extinction of a future obligation”.  This is what occurs when we repay our mortgage through our monthly payments.  It is also my question of the week, as I have had two people ask me if they should take money from their accounts and repay their mortgage.  What are the considerations in making this decision?

 

When you should consider paying off your mortgage:

·         When you have no other debts, such as credit card debt, at greater rates of interest.  If you are paying an APR of 18% on your credit card debt and 5% on your mortgage, pay your credit card debt first.  ALWAYS repay the highest APR loan first, if you have extra money to pay toward your debts.

·         When you have maximized your retirement savings, particularly up to the limit that your employer matches your contributions to your 401k, 403b, or other retirement plan.  If your employer matches 50% your contributions up to a limit, then making a contribution up to the limit is like an immediate 50% return on your money.  Besides, you don’t have to pay taxes on your contributions until you receive payments in retirement.  The Federal Reserve has estimated that approximately 38% of households making extra payments on their mortgage are making the wrong choice and underfunding their retirement savings as a result.

·         When you have established an emergency fund of three to six months living expenses.  This is one of the key steps in financial planning, as it enables you to face life head-on and handle those little and, sometimes, big things that come your way.  Importantly, an emergency fund allows you raise your deductibles on your property insurances, thus freeing more money for investing, as well as paying toward your mortgage.

·         When you do not believe you can earn rates of return greater than the rate of interest on your mortgage from your investments.  (I think this is what created this question to be so popular this week.  Yet, today (Thursday) as I write this markets are up about 2%.  I bet no one asks me this question today.)  As the recession eventually ends, rates of return will exceed current mortgage rates.  When that occurs, the money you spend on your house, could have been earning money for your child’s education, your retirement, or another life’s financial goals.

·         When the only reason you itemize your deductions for federal taxes is due to your mortgage.  Everyone receives the standard deduction of $5,700/$11,400 (single/married filing jointly).   Two-thirds of households take the standard deduction, rather than itemizing their deductions, as the standard deduction is the greater of the two for their circumstances.  If this is you, there is no tax benefit to itemizing your mortgage interest.   For those of you that really believe that tax deductions save you money, remember that they work this way: You pay $1 of interest and the federal tax deduction saves you $0.25 (assuming a 25% tax rate, more if you have state income taxes).  I’ll tell you what, you give me $1 and I’ll give you $0.40 for as many dollars as you want to give me.  That’s a 60% better deal than the one you get from the IRS.  I doubt I have many takers.

·         When you have already established an adequate insurance program; life, medical, disability-income are all particularly important if you have financial dependents.

·         When you are not already “underwater” with your mortgage.  It makes little financial sense to prepay, if there is a chance you may face foreclosure.  Besides, if you are one of these homeowners it is probably best to put your money in an emergency fund – which you may not have – in order to help you with your transition to a new life.

·         When you have a burning desire to be debt free.  I have no problem with people who want the sure “return” of not paying mortgage interest, as opposed to taking on the risk of investment markets.  Please, however, make the best decision for your circumstances, not the “one size fits all” answers of the radio talk-show hosts.

·         As it is a math problem and this is coming from a major university to you, consider the following.  We’ll assume a $100,000 mortgage with either a 30 or 15 year amortization period and either a 5.25% or 7.5% rate of mortgage interest, to illustrate the point.  For each of the four combinations, we’ll see how adding $200 per month to your mortgage payment will reduce your total interest paid, as well as reduce the time until your mortgage is repaid.

o    Regular Payment 15 year mortgage (repay in 180 months):

§  5.75% interest; $830.41 per month

§  7.25% interest; $912.86 per month

o   Regular Payment 30 year mortgage (repay in 360 months):

§  5.75% interest; $583.57 per month

§  7.25% interest; $699.21 per month

·         Savings from adding $200 per month to the payment for each of the above

o   15 year mortgage:

§  $14,490 interest saved and repaid in 131 months for the 5.75% mortgage

§  $19,643 interest saved and repaid in 130 months for the 7.25% mortgage

o   30 year mortgage:

§  $49,896 interest saved and repaid in 198 months for the 5.75% mortgage

§  $79,967 interest saved and repaid in 191 months for the 7.25% mortgage

o   Conclusion: A similar prepayment of mortgage principal is more advantageous the greater your mortgage rate of interest and the longer the amortization period of the loan.

·         Let’s do one more example, although it is a different problem.  Should you pay $100,000 cash for a house or borrow $100,000 at 5.75% to finance the house.  (This is similar to repaying a mortgage in full.)  The answer will depend on the rate of return you can earn on your money.

o   Option 1: Invest the $100,000 at 7%.  In 15 years the $100,000 would grow to $275,903

o   Option 2: Pay off the mortgage in full and faithfully invest the mortgage payment you would have paid at 7%.  In 15 years, the 180 deposits of $830.41 would be worth $263,208.  Thus, you are better off with the mortgage and keeping the $100,000 invested at 7%.

o   However, if you can only earn 5% on your $100,000 it would be worth $207,892 in 15 years, while the $830.41 deposits would be worth $221,959.  See, the answer depends on what you can earn on your money, as compared to the mortgage rate of interest.

·         As always, consult a qualified financial professional (or learn how to use a financial calculator) to address your particular situation with additional clarity, as an aid to your financial success.

 

 

Financial Aggregation Services

Andrew Zumwalt, M.S.

 

I consider myself an early adopter of personal finance. I get excited about new ideas and products in personal finance, and, when I can, I like to try out new products and features. I tried out the first peer-to-peer lending platforms, online savings and checking accounts, and other interesting developments in personal finance. However, I had trouble keeping track of everything. Rarely did I want to make a change, but I wanted to have a snapshot of all my finances in one place. About this time, the financial aggregation services were started.

 

Financial aggregation services pull all of your financial information together into one place. They provide an easy-to-understand overview of your assets and liabilities. They may also provide a quick glance at how closely your spending is matching your budget. The financial aggregation sites are able to provide this service because the client provides them with the usernames and passwords to the websites of the client’s financial institutions.

 

When I explain this to my students or other audiences, this step usually elicits some excited questions.

 

1. Aren’t you worried about someone stealing your identity?!

2. What happens when the service closes and they sell all your info?!

3. Are you crazy?!

 

These are all good questions, so let me answer each in turn.

 

1. Before I gave all my critical information to the financial aggregation services, I did some digging. First, I checked out the Wikipedia page for Mint.com, one of the largest aggregators. Sometimes, Wikipedia is not the best source, but I find its summary of information useful as a starting point, and it often has references that lead to useful information. The Wikipedia article on Mint.com points to quite a few news articles from the New York Times, the San Francisco Chronicle, and other media outlets. The Wikipedia article also let me know that Mint.com is powered by Yodlee. The Wikipedia article on Yodlee told me that Yodlee actually sells their aggregation software to several major financial institutions and other companies.

 

After reviewing the materials on Wikipedia and from other news sources, I actually visited both company’s websites to review their security practices and how they work. From Yodlee’s site, I determined that they seem to have strong, secure data protections. From Mint.com’s security site, I found that they only perform read-only actions; they never initiate changes within in my account. Note that I only go to the sites after I have vetted them from other sources. Trusting a site on its own merits can often lead to disaster.

 

After my review, I determined that the companies were legitimate. After I used the services for a time, I felt vindicated in my decision because Intuit, owner of Quicken and QuickBooks, decided to buy Mint.com on September 14, 2009.

 

2. In case you forgot, the second question was, “What happens when the service closes and they sell all your info?!” Although I’m not sure what every service would do when they close, recent events do provide some guidance. Wesabe, another financial aggregator, is shutting down their operations. They outline a series of steps they are taking to provide users access to their data until July 31st. On July 31st, they state that the personal data will be erased and the physical hard drives on which the data was stored will be destroyed.

 

Before Wesabe announced the closing, I had a hard time answering this question. However, I feel much more comfortable talking about financial aggregators, as the bar for closing a service has been set high. However, I would still advocate that individuals using a service that has closed change all their passwords just in case the data is not destroyed as planned.

 

3. Answering the third question, “Are you Crazy!?” is easy. No, I’m not crazy. From the short time I have tracked personal finance, I have only seen the field grow more complicated. We now have significant 529 plan enhancements, qualified dividends, the bottom 10 percent income tax bracket, Roth 401(k)s, and many more complex changes. Innovations and tools, like the financial aggregation services, help bring order to the complications of our personal finances. Combining the new innovations with education from eXtension, Missourifamilies.org, and the Office for Financial Success helps me and other consumers manage our finances.

 

In today’s tip, I’ve highlighted financial aggregators as a recent innovation in personal finance. I’ve also highlighted an approach to vetting the services and doing the research required to determine if you are comfortable sharing your information. As always, I’m interested in your feedback; if you have a comment, question, or concern, feel free to contact me at ZumwaltA@Missouri.edu.

 

Should I buy BP?

As a professor and a registered investment advisor I can’t count the number of times I’ve been asked the question, “Should I buy BP?” over recent weeks. 

 

As usual, my answer is, “It depends”, as it depends on a lot of factors: the questioner’s preference toward risk, their total portfolio of assets and their need for income, their desire to be a “green” investor, among other things.  It is difficult, as well as inappropriate, for an advisor to provide an answer to this question, without performing the due diligence required to understand the investor’s goals, their resources, their level of diversification, and the total family’s preferences.  Yet, I am continually amazed at how many of us remain eager to invest in new ideas, new “opportunities”, with little regard for what we do know about investments.  The most important thing we know about investments is diversification.

 

I recently came across a website assetcorrelation.com which provides visual aids to help investors focus on what I believe to be the principles of sound investing: discipline, diversification, and time.  Our focus today will be on the latter two, diversification and time, although having a disciplined financial plan and supporting it may be the most important of the three.  What do we see?

 

The following tables present intra-portfolio correlations for portfolios equally weighted between 1) countries, 2) industrial sectors, and 3) major asset classes, for time periods of from 3 months to ten years (in the case of Sector Diversification).  The intra-portfolio correlation can range from -1 to 1, with -1 representing the greatest amount of diversification and 1 representing the least diversification.  Another way to consider the intra-portfolio correlation is to subtract the intra-portfolio correlation from 1 and divide the result by 2 to provide the percentage of diversifiable risk that is removed from the portfolio through diversification.

 

	Country Diversification (15 countries)		Sector Diversification (10 sectors)		Major Asset Classes Diversification (13 asset classes)
	Intra-Portfolio Correlation	Rate of Return	Intra-Portfolio Correlation	Rate of Return	Intra-Portfolio Correlation	Rate of Return
10 year	NA	NA	0.64	1.4%	NA	NA
5 year	NA	NA	0.74	-0.2%	NA	NA
2 year	0.80	-5.2%	0.78	-8.0%	0.4	-7.0%
1 year	0.76	18.7%	0.80	16.2%	0.4	16.9%
6 month	0.79	-22.6%	0.84	-18.0%	0.4	-10.7%
3 month	0.84	-48.1%	0.87	-44.6%	0.4	-31.8%
1 month	0.83	4.2%	0.84	-36.1%	0.3	3.7%

Source: http://www.assetcorrelation.com/

 

The points I want the reader to consider are the following:

·         For the time periods we can observe, we find that the intra-portfolio correlation is, by and large, less the longer the period of time for which we have observations.  This is true for all but the best diversification strategy, major asset classes.  This demonstrates the importance of time to one’s investing strategy, as it takes time to reap the benefits of investment strategies.

·         Diversification across asset classes is superior to either diversification across market sectors and across countries, as a way to remove diversifiable risk from our portfolio.  This implies that asset class diversification should always be a part of our investment management plan, while we remain mindful of both country and sector diversification.  The asset classes used are represented by exchange traded funds and include TIPS; Gold; US Bonds; Emerging Market Bonds; Oil; Commodities; US Real Estate; International Real Estate; Emerging Markets; Europe, Australasia, Far East; US Small Cap Stocks; US Mid Cap Stocks; and US Large Cap Stocks.

What causes these results?  First, we know that to reduce risk you need to combine assets that have a low positive correlation or, ideally, a negative correlation with other assets.  Drawing from the two-year results, the longest time period we have for every category, we find that the level of positive correlation between groups is much greater for both the sector and the country results.  In fact, there are no negative correlations in either, while some mild positive correlations (between 0 and .80) exist.  Mild positive correlations exist in 40% of the sector correlations and in 23.8% of the country correlations.  On the other hand, for major asset classes, negative correlations exist in 20.5% of the correlations and mild positive correlations in 52.6% of the correlations or, rather, over 73% of the correlations are mild positive or negative correlations.

 

So, should you buy BP?  For financial success, my answer is simple, “It depends on what you need to add to your portfolio to reduce your diversifiable risk.”  If BP helps you reach your goals and reduce your diversifiable risk, I won’t discourage you from buying BP.  Otherwise, consider your total level of diversification and, perhaps, rebalance your assets with an eye toward diversification.