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Negative Financial Literacy

Knowing what not to do with your money is more important than knowing what to do with it…

The lament that people, by and large, do not know what to do with money is extremely common. Government regulators, the media and commentators like myself frequently point out that the lack of financial literacy is widespread, and that few people manage to make optimum use of their savings and investments. It is generally assumed that that this financial literacy must take the form of knowing what to do with money. That much seems obvious. However, this may not be true. When I see the actual ways in which a good proportion of people are actually mismanaging their savings, then it seems to me that problem lies elsewhere. It’s not so much that they don’t know what to do with their money, but that don’t know what not to do with it.

I’m not just playing with words here. Knowing what not to with money is not just the inverse of knowing what to do with it. It’s an entirely different type of financial literacy and I think it’s far more important than the other kind. Today, everything that comes under the term financial literacy boils down to teaching savers what to invest in. They are told how the investment world works, what the different types of investments are, who they are useful for, how to fit them into their financial needs and so on and so forth. There’s nothing wrong with this by itself. It’s all good, useful and sincere stuff and there’s no doubt that every saver must understand it thoroughly.

Unfortunately, none of this is actually much help in helping savers avoid situations where they actually go wrong. That happens when someone tries to hawk bad financial products dressed up as good ones and savers can’t recognise what’s happening. And if you are in the market for financial products, then sooner rather than later, someone does exactly that. There’s an old saying that bad money always drives out good money. The modern version of that is that bad financial products always drive out good ones. Why is that? Because the purveyors of bad financial products make more money out of them, almost by definition. Most of the time, that’s exactly why they are bad.

This doesn’t just apply to outright frauds like the recent case of a Citibank relationship manager who swindled crores from his customers, but also for financial products and services that fall within the borderline of legality. For example, let’s say that you invest in stocks and prefer to choose fundamentally sound companies and stay with them for the long term. You trade once in a while and every time you do so, your broker makes a little bit of money out of you.

In practice, if you are this sort of a customer, then sooner or later your broker will attempt to change your view of what investing in the stock markets is all about. Most likely, he will try and guide you into some highly leveraged high-risk action in index derivatives. His pitch will basically amount to telling you that you are a complete fool for ignoring the massive returns that are to be had for the asking if you follow his advice, except that he won’t mention the risk part till it’s too late. His actual goal would be to increase the volume you trade and therefore the commissions he makes.

The canonical example of such behaviour is of course in the insurance industry. The commonest example is when salesmen try and make you choose between ULIPs and term insurance. There are hardly any Indians who have enough (or even any) term insurance. This is the basic financial product that everyone must buy in a large quantity before they do anything else about their finances. And yet, even if you have the financial literacy to try and do so, there is an entire industry out there dedicated to diverting you towards ULIPs, because they can make far more money there.

Issues of new mutual funds are yet another example. Although, SEBI has cracked down on this now, all through 2005 to 2007, the mutual fund industry was busy creating a spate of flavour-of-the-day new funds, each only a minor variation of some existing fund. New funds were easy to sell because under the regulations of the time, fund companies could deduct high charges that could be used to pay commissions and finance intense advertising campaigns. The best thing for financially literate investors would be to invest in older funds with proven track records, but that wasn’t the way for fund companies and distributors to make more money.

So why isn’t it that teaching people what not to do doesn’t seem to come under the purview of financial literacy. I think the problem is that existing channels of financial education are committed to not being critical of anything. They’d like to be polite and not step on any toes, especially commercially powerful ones. Their modus operandi is not to tell people what’s good and what’s bad. Instead, they’ll talk only about the good things and keep quiet about the bad ones. That’s only half the job done and the less important half at that.

This makes the whole exercise pretty much useless in this very important way. For the investor, not doing the wrong things should actually be learnt before doing the right things. Unfortunately, this is something that they’re likely to learn the hard way, through their own experiences.