Financial Knowledge Matters, But This Matters More
By: Erik Bassett
Tags: Money, Budget, Personal Finance, Budgeting

We’ve all been there. Whether it’s a regrettable “twenty-one run” or a Mario Andretti impression on the freeway, we’ve all done the very things we warn others against.

Knowledge doesn’t ensure prudence in those areas (among countless others), and it turns out that personal finance is no exception.

You learn this anew every time you wince at a credit card statement. But was that silly purchase just a fleeting indiscretion, or are humans so systematically bad at turning financial awareness into financial prudence? And if so, what’s the missing piece?

Photo by Kuma Kum on Unsplash

Does financial knowledge keep us out of debt?

College students face not only boundless opportunities for boorish drunkenness but a barrage of credit card advertisements. For around three decades, credit card companies have used every available medium to put easy credit in front of often cash-strapped young people. Whether that’s right, wrong, or simply a fact of life is an important question, but the promotions are ubiquitous in any case.

That made them an ideal group for Drs. Cliff Robb and Deanna Sharpe to study for their 2009 paper. To understand how personal financial knowledge played out in real life, they surveyed the student body of a large university with half a dozen simple, multiple-choice questions about interest rates, credit history, inflation, and risk versus return.

It’s common knowledge that carrying a credit card balance results in (often astronomical) interest payments, which can hamper savings for years to come. You might expect, then, that the more financially knowledgeable students — the ones with the most correct answers — would generally have avoided carrying a balance like the plague. Even the authors expected as much.

Yet, in reality, the researchers note, “those with higher levels of financial knowledge had significantly higher credit card balances.”

Perhaps they were poorer students who learned all about interest rates from the school of hard knocks? No, that’s not it, either. It turns out upper-income students were actually likelier than their low-income peers to carry a balance in the first place.

(Perhaps that shouldn’t be such a surprise, though. Direct-mail offers are especially effective, so if I were an unscrupulous credit card company, then I’d bombard households of wealthier parents who might be more able to bail out overdrawn children.)

The impact of knowledge and parental income were both statistically insignificant, meaning (in this case) sheer randomness would produce at least as large an effect more than 5% of the time. That’s far from a useless finding, however. The lack of a clear relationship is a compelling argument that knowing financial facts does not lead to avoiding credit card debt.

It simply may not matter much either way — or at least it pales in comparison to other phenomena.

What’s really going on?

Robb and Sharpe incorporated dozens of factors, some more interesting and generalizable than others. Older, financially independent, and in particular married students were likelier to carry a balance, which “suggests that at least some students may be using credit to compensate for low of financial resources.”

That’s undoubtedly true in many cases.

If cash-strapped students carried higher balances (e.g., to put food on the table), then you’d also think bigger borrows would have an attitude of cynical frugality. A relentless inner voice of “I can’t afford this” would more or less predict card balance.

Luckily, the authors measured exactly this cynical frugality (they unintuitively called it “distrust”) by way of questions like:

“I automatically say, ‘I can’t afford it’ whether I can or not.”

“I hesitate to spend money, even on necessities.”

“I argue or complain about the cost of things that I buy.”

And this is where things where things get interesting.

You’d think those statements were typical of someone who actually needs credit to make ends meet, but the truth was the exact opposite. Cynical frugality — “distrust” — was a remarkably significant predictor not of reckless borrowing but of a smaller balance and lower odds of carrying one, to begin with.

That’s right: it wasn’t financial savviness or even parents’ wealth that predicted less borrowing, but an inner voice saying, “I can’t afford this.”

That attitude may be part nature and part nurture. I’m no expert in either and won’t begin to speculate. But this much is clear: no matter how much we understand on paper about comparing APR or about the woes of vigorous 21st-birthday celebrations, our mindset will prevail.

And so it’s our mindset — by nature a generator of impulses and justifier of excesses — that we must focus on for a sound financial future.

The tricky thing about financial knowledge

As post-college adults (I assume most of you are), financial life is a little more complicated. We unquestionably need to understand the moving parts in credit history, financing charges, investing fundamentals, and a host of other concepts.

But I submit that it’s too instinctive, too tantalizingly easy, to weave that knowledge into elaborate justifications for what are really no more than unexamined impulses. To wit:

“If a piece of plastic gets anything on my doorstep this week, then why can’t I afford it? The transaction went through, and I’m building my credit history anyway.”

“If I have weeks or months or technically the rest of my life to pay for that outing, how does the amount even matter? You know, only X% of people pay off credit cards at all, so I’m already Y% ahead for my age.”

Thus easy credit leads us very subtly down a path of lifestyle inflation. Not inevitably, not universally, but horrifyingly often, we coat instant gratification with just enough figures to form a veneer of rationality.

Internalizing good financial choices

When we identify profoundly human tendencies — like those of rationalization and instant gratification — then we expect to find confirmation in surveys, just as we’ve seen above.

We also expect to observe those tendencies in our own lives, in both finances and twenty-first-birthday revelry alike.

How, then, can we do better?

The first step is to realize every penny you spend serves some end, and it’s critical to know what (you believe) you’re achieving.

The key to prudent decisions with money and all else is to tie them to a purpose. If we don’t have a conscious one, then our unexamined impulses are all too happy to fill in.

For me, the financial secret (pardon the melodramatic word) was to develop a laser-like like focus on two things:

A simple daily life, “minimalist” by North American standards that explicitly acknowledges the futility of seeking happiness in stuff

Freedom and peace of mind for my family, with enough financial wherewithal to absorb life’s surprises yet ample free time to enjoy and share in life itself

The second step is to turn your priorities into a clear and extremely simple daily plan. I often call it a “budget” since the term is universal, but it’s less about rules and allowances than about passing every choices through the filter of: is this necessary or fulfilling?

Nobody can chart that entire path for you, but my own experience getting out from burdensome student debt may be helpful. Along those lines, these universal tips to get started should be more relevant than not.

Knowledge can facilitate action, but knowledge itself is not action, let alone purposeful and congruent action. So study up — especially if you’re from a challenging financial background — but focus above all on a mindset of simplicity and healthful frugality. Otherwise, you leave a door wide open for smart marketers and your own impulses to hijack that knowledge against your own best interest.