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What you don't know you don't know

Savers and investors have a vast knowledge gap when it comes to investments, and this gap is worse for those who need the knowledge most

What you don't know you don't know

How do you buy things? Think of the things that require a certain amount of evaluation, say clothes, or footwear. You go to a shop, look at a range of options, try out a good number of them, make your choices, and then go out and order them online from your smartphone. Of course, there was also an older way of shopping but I don't know whether anyone does that now.

Either way, the reason why such an exercise works is that you have some criteria on which you can judge the options available. Depending on what you are buying, these could be subjective like taste or colour or smartness, or they could be objective like price or quantity or some other specification, as in the case of gadgets or automobiles. In either case, you think that you have made the right choice, according to whatever criteria looks most relevant to you.

This is something you grew up doing and you don't even think of the actual steps. Unfortunately, buying financial products - whether for investments or insurance or something else - doesn't quite work out like this. Firstly, relatively few people can accurately map what they desire from a financial product to a realistic chance of that product actually having those characteristics. Secondly, even if the product has the characteristics you desire, evaluating them is often too dependent on the investor having the right background knowledge, a mental model for understanding what goes on inside the product, as well as the scepticism to resist the hype that inevitably surrounds the product.

The worst part is that the realisation that one had made a bad choice often comes only after years, if then. There are plenty of people whose investment and insurance choices have done badly but they are only vaguely aware that they could have been better. Or even if they are, they don't really understand what went wrong. The impact that these choices have on people's lives are huge, and yet they get far less attention than the choice of a mobile phone or a pair of shoes. Unfortunately, there's no easy way out. Some people will bootstrap their knowledge and learn, but the ones who need a solution most don't even know it.

What I'm saying about knowledge and understanding is not a general motherhood statement. There's a specific issue here, which is that savers and investors need to understand how things work. Banking, insurance, stock markets and mutual funds look like black boxes to most of us. Not only do we not understand the model, we don't understand the people. Therefore, we often don't recognise the motivations and goals of the people we are dealing with. Without a mental model of how things work, one can't deal with problems that arise. I read somewhere that when a car doesn't start on turning the key, most drivers turn the key harder, putting more pressure on it. Subconsciously, they feel that the turn of the key starts the engine, whereas in fact, the key is just an electric switch. It's like pushing a light switch harder to try and make a bulb brighter.

For most of us, personal finance services are a hard thing to form a mental model of, certainly harder than cars. If we understand exactly how a service works, who the provider is, who the seller is, how they make money and how they will try to make more money; and especially where you fit into their scheme of things, only then we can make better decisions.