Guess how many Americans correctly answered this basic financial question: Is the stock of a single company usually safer than a mutual fund?
A) 100% B) 80% C) 60% D) None of the above.
The right answer is D. Barely 1 in 2 people knew that a single stock is not safer than a mutual fund, which holds many stocks.
The question, included in a survey by a pair of college professors, underscores a fundamental problem facing millions of Americans. At a time when the world of personal finance is increasingly complex — and when people are more responsible than ever for their own financial future — Americans' understanding of basic concepts is sorely lacking.
Despite many efforts to boost knowledge, studies show that most people don't understand rudimentary principles of finance and investing. Even well-educated and upper-income Americans often have poor financial literacy, experts say.
"By and large, people are pretty clueless," said Olivia Mitchell, executive director of the Pension Research Council at the University of Pennsylvania and coauthor of the study.
A 182-page analysis by the Securities and Exchange Commission last year found that "investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud."
The result, experts say, is young people who are mired in student debt and older Americans who face bleak retirement prospects. People who don't understand basic concepts are ill-equipped for more complex tasks, such as ferreting out hidden fees or conflicts of interest that are embedded in many financial products.
The collective ignorance has played a role in recent financial crises, according to some experts. The subprime mortgage meltdown would have been less severe, they say, if people understood the pitfalls of the loans they were taking out.
The SEC study was part of the Wall Street reform law passed by Congress in the aftermath of the 2008 global financial crisis. The goal was to improve Americans' investment knowledge.
That is a key issue for the millions of individuals who poured into bonds in recent years. With interest rates expected to rise in the next few years, studies show many investors don't understand the potential impact.
A survey by the Financial Industry Regulatory Authority, a Wall Street-funded watchdog organization, found only 28% of respondents knew what happens to bond prices when interest rates rise. (Answer: The value of existing bonds falls when new securities with higher yields are issued).
"As reading and writing were essential to participate in society in the past, today you have to be financially literate to participate in society," said Annamaria Lusardi, director of the Global Financial Literacy Excellence Center at the George Washington University School of Business.
The lack of awareness is partly the result of a profusion of financial products, experts say. There are endless varieties of mutual funds and mortgages. Students must sift through the arcana of college loan terms and repayment options.
Even picking a financial advisor isn't easy. Investors must decipher whether the person is a skilled advisor with legitimate credentials or a broker pitching risky financial products that pay high commissions.
"The decision to go to a financial advisor requires financial literacy because you have to choose the right one," Lusardi said.
There are competing theories about how to overcome financial illiteracy. Experts such as Mitchell and Lusardi say personal finance should be taught in schools. That would instill basic concepts, such as the power of compound interest, at a young age.
Other experts say financial education is unlikely to meet with great success. Instead, they say, the focus should be on simplifying financial products so that people have fairer and more straightforward options.
An example would be target-date funds in 401(k) retirement plans. Investors specify the year they hope to retire and fund managers make automatic adjustments on their behalf.
Americans' lack of financial awareness is becoming an increasing concern of employers.
The motive isn't altruistic. They're worried that anxiety over high debt and poor retirement planning could divert workers' focus on their jobs and increase stress-related healthcare costs. They also don't want to be stuck with workers whose passion flickered out long ago but who cling to their jobs for the paycheck.
After years of beefing up their 401(k) websites with tutorials and calculators, some employers are going a step further by hiring companies to offer more detailed and personalized financial guidance. One such advisor is Financial Finesse in El Segundo, which offers help on issues such as retirement, college planning and taxes.
Liz Davidson, the firm's chief executive, said the assistance prods employees to become financially disciplined.
"The vast majority of people in society know 'I need to manage my spending, my debts and have some [money] set aside for emergencies,'" Davidson said. "But they're not taking the steps, at least to the extent they need to do so, and that's a behavioral issue, not a knowledge issue."