The importance of being financially literate

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.