31 May 2007

Investors don't know what they don't know

Here’s a reality check about financial literacy. American Century conducted a short 10-question survey of 680 Americans between the ages of 18 and 41 and found that less than half understood the fundamentals of a well-diversified portfolio. I found this shocking result the Chicago Tribune on Sunday May 27 (as well as some other publications): Less than 20% could recognize the definition of asset allocation.

The survey posed the following question: "Which of the following is true about asset allocation?"

  • Asset allocation is a strategy where investments are divided among different asset classes such as stocks, bonds and cash.
  • According to academic studies, a portfolio's investment returns over time are based mostly on its asset allocation.
  • Asset allocation lowers a portfolio's risk because losses in one type of investment are offset by gains in others.
  • All of the above.
  • Don't know.

Only 14% of Younger Adults (age 18 to 26) picked the correct answer -- "all of the above." Generation Xers (age 27 to 41) faired only slightly better as 18% responded correctly. To their credit, 60% of the Younger Adults and 49% of Generation Xers chose "don't know," suggesting they are more inclined to admit ignorance (but also to learn) than to try to guess.

What this tells me is that financial literacy is not where it ought to be. Financial advisors tend to assume concepts like asset allocation and diversification are common knowledge. And, as an industry, we tend to focus on more sophisticated matters like Modern Portfolio Theory and products like hedge funds. But after years of financial education, the market needs are much more basic.

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