San Leandro, CA

Wednesday, October 21, 2009

This is the first chapter of a book on Financial Risk and Failure: The New Order of Investing.

The chapter, Financial Educational Failure, shows how instruction to school children has, and will continue to, entice a system of outright gambling. It is clear that the current financial debacle will happen all over again because the major focus of instruction violates the very tenets of investing. But the adults are no better since they are doing the same thing.

We need a wholesale change of education. This book and my upcoming videos will be a start.

Financial Educational Failure

This probably says it best- How Ordinary Consumers Make Complex Economic Decisions: Financial Literacy and Retirement Readiness, http://www.nber.org/papers/w15350

NATIONAL BUREAU OF ECONOMIC RESEARCH

"There can hardly be a better time to make the case for economic and financial literacy... a better-informed citizenry would likely have resulted in more prudent decision making and, consequently, less harm to the economy."

That certainly has been an issue for decades but I am not sure anyone will make the concerted effort. And what effort there is as apt to be a rehash of the same ol', same ol'. A fine example is BetterInvesting.org (formally NAIC- National Association of Investment Clubs) and this comment at their site - We show you how to beat the market. (There are no legitimate texts that suggest that that is nothing more than charlatanism and gambling.) Before 2000, they had a membership north of 570,000 (WSJ February 2007). Then as of 2/2007- and that is after a few good years of returns- the membership was no more than 140,000- dropping lower to 95,000. Thousands of "investors" milling around in a non sophisticated environment finding the next best stock or fund that would produce fantastic returns- only to finally recognize they were clueless to the elements of diversification or to economic risk. The idea that a focus is on 'beating the market' is a denial of diversification.

They also show you how to pick stocks via all sorts of stats from the past. Unfortunately, that is a violation of diversification since one needs far too many stocks (350) to be picked by an individual. From Benoit Mandlebrot and identified herein, "to build efficient portfolios, you need good forecasts of earnings, share prices, and volatility for thousands of stock. Otherwise garbage in, garbage out. Finally, for each stock, you must laboriously calculate its covariance with, or how it fluctuates against, every other stock. For a thirty stock portfolio, about the minimum needed to make the numbers work well, that means 495 different calculations of mean variance and covariance. For the entire NY Stock Exchange, 3.9 million calculations. And because prices change, the exercise needs constant repetition."

The ability for consumers to construct a portfolio on simplistic ideology is a waste of effort. The success is shown by the numbers. No organization goes from 570,000 members to 95,000 if they are doing the right thing. The loss of 80% is indicative of the failure to get to the real life application of stocks.

From a 2009 article, FINANCIAL LITERACY AMONG THE YOUNG: EVIDENCE AND IMPLICATIONS FOR CONSUMER POLICY, http://www.nber.org/papers/w15352, NATIONAL BUREAU OF ECONOMIC RESEARCH.

Previous research has found that financial literacy can have important implications for

financial behavior: people with low financial literacy are more likely to have problems with debt

less likely to participate in the stock market), less likely to choose mutual funds with lower fees),

"As the complexity of financial decisions increases and individuals are put in charge of

making these decisions even at a young age, it is important to find ways to equip people with

adequate financial knowledge. Previous studies have shown that broad groups of the population

are not financially literate; these people may be particularly unlikely and unable to manage their

finances effectively, and to plan adequately for the future. This paper added to the existing

knowledge by exploring what younger adults know and do not know as determined by a set of

simple questions that assessed their financial literacy. We found that financial literacy was

severely lacking among young adults; only 27% of young adults know about inflation and risk

diversification and can do simple interest rate calculations. Moreover, women proved to be the

least financially literate. Sex differences between women and men persisted even after

accounting for many demographic characteristics, family background characteristics, and peer

characteristics. Prior work showed that women tended to display low financial literacy later in

life. Thus, lack of financial literacy seems to persist for long periods and sometimes throughout the lifetime. Given the strong link between financial literacy and financial management and retirement planning found in other studies, it may be important to find ways to foster financial knowledge in the population as a whole and among the groups who are more disadvantaged. Similarly, it may be important to develop programs targeted specifically to women, since they display not only much lower financial knowledge but also large differences in investment and saving behavior.

I did respond to the authors with this- 'First a comment to risk diversification- it is effectively a sophomoric commentary overall as is evidenced by the lack of material at the SEC and FINRA level. Diversification is not "don't put all your eggs in one basket". Just one comment- when you mention risk diversification, there is effectively no one no who knows the correct answer. No broker has been taught the fundamentals of investing, nor no CFPs et al. It is one thing to infer the young don't know risk diversification but the adults are using the same sophomoric rationalization. The"don't put all your eggs in one basket" is statistically useless unless validated by numbers reflecting risk.

When used with securities, it is how many stock must you have in a portfolio in order to insulate it to unsystematic risk. More colloquially. how many stocks must you have in a portfolio in order to be properly diversified;

It is a minimum of 50 stocks to the preferable 350. Unless the numbers are presented for real life application, it seems to me that the issue of education for financial literacy and retirement planning is suspect. Those numbers have to be taught."

Admittedly my note was more than they needed for the report, but their reply was even more damaging to financial literacy: "Point well taken, we are aware, but we cannot ask people about the stocks' beta (?). We got most of the predictive power from the "do not know" answers, basically respondents do not know what a stock or a stock mutual fund is."

That says volumes on how bad our educational system is doing. Just terrible. The material can be mastered if the instruction of the basics are followed. But there can be nothing to entice the novice to gambling- which has been the presentations to date. Here is an example last year from the California Financial Literacy Summit sponsored by the California CPA Society. One would assume some mastery of the fundamentals of investing would be evident to provide to an audience of 500 teachers but the presentation revolved around a PBS fluff video on "gambling". It showed a young student about 12 who had decided to buy Nike stock by just reviewing a couple statistics. And then relying on his mother for advice. That's it. Well, he was successful with just one stock. And then he started to teach other kids what to do. The school he was at was impressed because the other kids were impressed. It was fun. It was easy. And it was profitable. Risk was not even an issue.

That may be nice but the focus on a singular stock defies the first fundamental of investing- diversification- and is the same thing as gambling. No matter, PBS does a 'feel good' piece that was being shown at schools across the country because it got the kids excited. Sorry, that is the wrong emotion for investing. It is  emotion that is potentially the downfall of successful investing. No matter, all in defiance with basic risk. So where the basic financial literacy? It sure wasn't PBS. It was not the CPA society. And all being delivered in a cutesy sophomoric piece of drivel that will only perpetuate the ignorance and illiteracy of the public.

Here is a far worse- yet more national and institutional- corruption of investing. This one is from the Ohio Centers for Economic Education and Financial Literacy Stock Market Challenge. http://ohiosmc.stocktrak.com There are many others like it. "This is a web-based educational tool that is used by thousands of elementary, middle, and high students around the state each semester to help teach economics, finance, current events, math, social studies and technology. Each student or team of students receive $100,000 of virtual dollars in an SMC brokerage account and simulates managing a portfolio by buying and selling stocks at real-time prices. Students compete for prizes and/or statewide bragging rights."

Another SMC said this- "Stock Market Challenge brings the unique excitement of live trading into the classroom. This interactive, experiential learning resource uses the experience of trading to create a competitive and rewarding team activity."

One of their research notes says, "Diversify your investment in at least three or more different stocks." I suppose one could say that 350 stocks fits in with "more than three", but that is an absurd rationale.

I do not dismiss that there becomes an interest in some element of math, current events and more, but the SMC is a two week challenge to take as much risk as one can possibly imagine to beat another team doing the exactly same thing. This is a ludicrous and dangerous exercise that is designed for a project that totally inviolates long term planning, diversification, etc., and drives the risk of loss almost to exponential levels. These are tantamount to new age video games sending the wrong message- TRADE, TRADE, TRADE!!!

This challenge is offered in all the states. And even at some universities. It sends the completely wrong message about investing. It is gambling. Such activity has previously devastated retirement assets. As long as this focus on illiteracy continues, the school age kids will do no better as they get older. But a current problem is that the teachers believe it too right now. And their state administrators. And our government.

This is the real life financial and investment literacy of our nation. It has to be completely re-engineered. But I do now know who will do it since the government leadership is suspect at its core.

Errold F. Moody, Jr.

PhD MSFP MBA LLB BSCE

Life and Disability Insurance Analyst

San Leandro, CA

510-352-4127