The OECD (Organisation for Economic Co-operation and Development) defines financial literacy as a combination of financial awareness, knowledge, skills, attitude and behaviors necessary to make sound financial decisions and ultimately achieve individual financial wellbeing. Simply put, financial literacy is all about being ‘financially smart’.
Why do we need financial literacy? Firstly, it helps us to efficiently articulate the path that our money needs to take once it enters our bank account. It also helps us to assess the risk of various investment avenues better, as well as mitigating the fear of investing in market-linked capital market instruments.
For example, a financially literate person understands that derivatives can be riskier than direct stocks which in turn can be riskier than equity unit trusts. Without financial literacy, all three would have been grouped in the same basket and one would have mostly refrained from investing in any of these instruments for fear of losing money.
It is the financially illiterate that are targeted by Ponzi investment schemes run by ‘fly by night’ operators. Gullible investors have poured millions into these dodgy schemes, lured by promise of high returns. Besides this, there are some simple day-to-day examples which point to the need for better financial literacy.
For example, if an investment has doubled in six years, some may say that the returns are 16.67% per year or 100% in six years (100% / six years = 16.67%) when the actual returns are 12.3% compounded annually. The financially illiterate fall prey to higher returns shown by such calculations while the financially literate, in contrast, end up questioning the period of compounding (whether quarterly or half yearly).
Thus financial literacy not only lies at the bottom of the pyramid, but across the wealth hierarchy, although the proportions may vary.
How does financial literacy help? I have observed that most South Africans follow a ‘one size fits all’ approach when it comes to investing. The preference is for stereotypical investments like gold, real estate and bank fixed deposits. There is only limited use of collective investment products such as unit trusts. While gold and real estate are long term investments, the rest are used on an ‘as and when needed’ basis.
There is no concept of goal based investing. The biggest risk of an ‘aggregated’ approach like this is that investments invariably end up being utilised for early or front-end goals with very little left for rear-ended goals like retirement. Even some ‘long term’ investments, like gold and real estate, get used for ‘big expenses’ like weddings in the family or other exigencies.
Financial literacy helps one to move from an ‘aggregated’ investment approach to a ‘segregated’ investment approach, wherein each goal is backed by a separate investment portfolio. Though it may not have a big theoretical backing, the ‘segregated’ approach is practically better as there is no overlap or spill-over happening from one goal to another.
Along these lines, financial literacy helps to understand the risk based approach to investing, meaning that one should invest in less risky investments in the short term and target relatively riskier avenues like equity for the long term. This enables investors to benefit from their higher wealth creating potential for crucial goals like children’s education/ marriage, retirement, etc.
Unlike those who feel that equity markets are risky, a financially literate person would understand that one can invest in equities through unit trusts which are professionally managed. One can further reduce risk by increasing the tenure of equity investments to 5, 10, 15 or 20 years to reduce the chances of any negative returns. One also builds awareness about facts like ‘one must not time the market’ but invest in small amounts, regularly and over the long run. Time in the market can be more important than timing the market.
Challenges to the spread of Financial Literacy - The poor state of financial literacy in the country is evidenced by the fact that only a small percentage of South Africans regularly invest their savings in unit trust vehicles. The biggest challenge therefore is to change the investment psyche first from ‘physical assets’ to ‘financial assets’ and from financial assets from ‘assured returns’ to ‘market linked returns’.
For example, a traditional savings instrument is predominantly debt oriented and declining interest rates would lead to a lower amount available on retirement which may not suffice the post retirement phase. It is therefore important to supplement provisioning for the future by regular savings in market linked investments like unit trusts funds which have the potential to provide higher inflation adjusted returns.
What is the solution?
Basics First
If we want our next generation to be financially literate, we need financial education to be part of the school and university curriculum. The basic lessons of investment must be taught in school/ university. Once again it is important that this is not a tick-box initiative as students must understand the basic nuances of investments so that they can take informed investment decisions in future to meet their life goals.
Technology and social media
They can be a big enabler in increasing the ambit of financial literacy. The mobile phone could be the key driver for this change. All stakeholders could pool resources and encourage ‘fin-lit’ start-ups to help build scale. Technology can be used to spread financial literacy in a ‘fun’ way through games using mobile apps.
Public and Private Partnerships
Increasing financial awareness in a large and diverse country like South Africa will have to be a long term effort built on a public – private partnership involving the government, regulators, industry associations, financial sector players like banks, unit trusts, insurance companies and financial product distributors.
Simplified messaging
The communication to investors must be very simple, consistent and without jargon.
A well informed and fully aware investor base is important for a growing economy like South Africa as it fosters financial stability. While the Financial Services Board has its own financial literacy initiatives, we need many more hands on the wheel to build the momentum that is necessary.
