We Need a New Definition of "Financial Literacy"
Read this post if you want to learn how to make better money decisions
We desperately need to expand the definition of “financial literacy.”
That was the main takeaway from an interesting research paper I recently read. The author points out that financial literacy is too narrowly defined as someone’s knowledge about financial issues.
Many people point to a lack of “financial literacy” as the reason so many people struggle financially.
***As a quick aside: the real reason most people struggle financially is because they don’t make enough money, not because they make poor choices. Never forget that all wealth is created first from income and then from making smart decisions with that income.***
Yes, it’s important to have knowledge about financial issues, and the good news is that there are loads of resources to obtain financial knowledge.
But, many people with financial knowledge still make poor financial decisions. Knowledge alone is not enough. Improving financial behavior is key to improving your financial outcomes.
Financial literacy is knowing what to do.
Financial behavior is doing it.
Add those two things together, and you get better financial outcomes.
If you know what to do but don’t follow through, what can we attribute that failure to?
A lack of self-control.
You knew you only wanted to spend $400 at Costco, but once you got in the store, you kept your shopping list tucked in your pocket and sent $700.
Many financial plans fall apart due to a lack of self-control.
Although, as I have covered in detail in a previous post, self-control is not about “willpower” it’s about having a plan:
Does Strong Self-control Lead to Better Money Outcomes?
Every time you leave your house or go online, nearly everyone tries to get you to part with your money. There’s nothing wrong with spending money as long as you spend money on things that make your life better and you can afford. The problem is that we are constantly bombarded with advertisements and social m…
How to never overspend on the holidays again
The research paper I referenced above was written by Hersh Shefrin from Santa Clara University. Shefrin comes to the same conclusion I do and highlights how a lack of self-control causes people to blow through their holiday spending budget.
According to Shefrin, 55% of households have a budget for how much they want to spend during the holidays. But 36%, with a formal holiday budget, spend more than they planned—by a lot. Those who stick to their budget spend 63% less money during the holidays than those who don’t.
It’s very easy to give in to the temptation to spend during the holidays—especially if you have young kids.
It requires self-control a plan to avoid overspending on the holidays, even if you have a budget.
I’ll use Christmas as an example. When is the best day to start saving for next Christmas? On December 26th.
Start by tracking how much you spent on Christmas this year.
Are you happy with that number?
If yes, that is your budget for next year.
If not, ask how much less you would like to spend next year.
Divide that number by 12 and automate those savings into a “holiday fund.” Then when the holiday rolls around, you spend exactly what is in the holiday fund. Notice that this doesn’t require advanced financial knowledge or willpower to resist overspending.
It requires some work upfront to figure out your ideal holiday budget, then automate the savings.
That same process can apply to any holiday, birthday, or occasion that happens every year, and you will be tempted to overspend.
Other ways to improve “financial literacy”
One of my unpopular opinions is that I don’t think it matters all that much whether we teach personal finance in school. When we learn in a formal classroom setting, students forget 97% of what they learn within a month.
A more effective way to teach people about financial issues is right before they need to make a decision. For example, the best time to learn how mortgages work is right before you need to refinance yours.
I’ve written more about the need for “just in time” financial literacy here:
Financial Education Doesn't Work, Do This Instead
Few problems are as widely agreed upon and misunderstood as financial literacy. Politicians, the general public, and personal finance experts agree that most people’s lives would be improved if they were taught how money works. The point I continue to drive home through the “
I’ve often argued that financial literacy should also cover basic math skills. It’s one thing to be able to understand the definitions of technical jargon like “amortization” on your mortgage statement. It’s another to understand the math behind it well enough to know whether or not you’re getting a good deal on your mortgage.
Math that can help you get better with money is called “financial numeracy.” If you want a detailed breakdown of all the ways financial numeracy can help you improve your financial decision-making, read this post.
Bottom line
We need to expand the definition of “financial literacy” to include things like self-control and financial numeracy.
A better version of financial literacy is teaching people what to do and how to follow through.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
I spent a bit of time helping people understand finances and it amazed me what people didn’t know. Basic things like budgeting were foreign concepts.
I also like your statement about income. A lot of people who teach about finance don’t focus on increasing your income, only on managing your money better.
The "stranger test" works for a lot of impulse buys. If you want to buy something, first ask yourself: If a stranger offered me the item or its monetary equivalent, which would you choose? If you choose the money, you should not make the purchase.