A Financial Literacy True-or-False Quiz Reveals Whether We Understand Diversification

By Markets Fool.com

On this week's Rule Breakers podcast, Motley Fool co-founder David Gardner's guest is Dr. Annamaria Lusardi, the Denit Trust Chair of Economics and Accountancy at George Washington University, as well as the founder and academic director of its Global Financial Literacy Excellence Center. A well-regarded expert in her field, she is known for a piece of research she did involving a three-question financial literacy quiz.One hopes that every regular visitor to The Motley Fool would ace this test, but in this case, we're more interested in what each question measures and what getting it wrong signifies about a person's financial know-how. For the final question, the researchers were curious to see if we understand how to reduce our investing risk.

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A transcript follows the video.

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This podcast was recorded on Oct. 5, 2016.

David Gardner:and that takes us to question No. 3. This is a true or false question -- my favorite as a schoolboy ...

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Annamaria Lusardi:Mm-hmm.

Gardner:... the ones I really love -- true or false. My odds were up for these. And here it goes. Please tell me, you write, whether this statement is true or false: Buying a single company's stock usually provides a safer return than a stock mutual fund. True or false -- buying a single company's stock usually provides a safer return than a stock mutual fund. Five seconds of fairy dust. All right, I think we've all arrived at our answer. Dr. Lusardi, what is the correct answer to question No. 3?

Lusardi:So it's false, and it's false for several reasons. Here this is a joint test of knowledge of what is a stock, what's a company stock, what's a stock mutual fund, and also what's the safer of these two normally. And so, of course, you know, we cannot ask here what's the beta on a specific company stock, but we are asking do you know that, you know, one asset is normally riskier than a basket of assets and it is safer to have, in a sense, a diversified portfolio. In other words, if you put all of your eggs in one basket, it's much riskier.

And this is, of course, a much more complex question, and because we only have an opportunity to ask three questions, this is a question we ask so we are able to differentiate across levels of financial knowledge.

Gardner:So I am guessing (and I've done my homework, here, so I have to admit I'm not just guessing) that this, of the three questions, is the one that stumps most people.

Lusardi:Yes, and it stumps them in two ways. So we see that the pattern of responses, here, completely changes with respect to the first two; which is, first of all, the proportion of correct answers, here, drops quite substantially, and normally only half of the people, of the respondents that we ask this question, is able to answer correctly. And as you indicated, by the way, you know, here you're going to have a multiple choice, and so it would be easier to guess correctly, right?

Gardner:That's a really good point.

Lusardi:Yeah, that's why, you know, people like it. But what happens here, instead, is a lot of respondents choose one of the other two options, meaning they actually say "I do not know."

Gardner:I see.

Lusardi:So this is one of the questions where people say "I do not know," and they mean it. I think they do not know what this question even means, and they actually do not know the answer.

Gardner:And a lot of people -- and this is certainly true of some people in the United States, I suspect it's even more true of other places in the world -- a lot of people don't know what a stock is...

Lusardi:Right...

Gardner:... let alone a stock mutual fund.

Lusardi:Right, absolutely. And we know this because of other surveys we have done, so when we ask what a stock is, and what is a bond, we see that people actually do not know. Do not know the distinction between a stock and a bond, and do not know what a stock mutual fund is and does, as well.

Which is important, right, because today, people are asked to invest, for example, in their 401(k)s. And, you know, we have, of course, we discuss a lot about investing, but the reality is, a large proportion of the population doesn't know the difference between a single stock, or doesn't know what a stock mutual fund does.

And also doesn't know about risk diversification, which is really what this question is meant to capture. And we have asked this question in many different ways, so it doesn't have to be in a sense so complex -- it doesn't have to be so jargon-laden -- but even if I ask it in different ways, in fact, this concept of risk diversification is the one that people know the least.

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