In a free market, individuals are supposed to patronize companies that provide a fair product at a fair price (value). Produce what the market needs and you have a viable business. Fail to deliver what the market demands and your business is toast. After all, if you bought tire brand A and the tires blew up, you would stop buying them right? Tire brand B would take market share by offering a better product at a price deemed worthy and put tire brand A out of business. Nothing terribly inciteful about that, just common sense right? The result is increased competition to satisfy consumers and healthier businesses.
For this to work across the economy, consumers need to be able to make reasonably informed buying decisions. If people don't stop buying tire A, tires will never improve in quality and consumers will keep buying inferior products that are dangerous to their health (financially and physically in this example). In fact, if tire A succeeded, it would create a perverse incentive for the tire company to cut costs and quality even more in the pursuit of profits. In other words, if consumers make relatively intelligent buying decisions the free market ought to deliver superior choices over time.
It follows that consumers must make reasonably informed decisions for the free market to work (this is where the power of a brand comes from by the way). Yet consumers can be uninformed and ignorant when it comes to financial matters. Tales of financial mistakes are widespread. Take for example a recent study by University of Geneva which surveyed people on basic financial literacy. By "basic", I mean questions such as:
"In a sale, a shop is selling all items at half price. If a sofa cost $300 before the sale, how much does it cost now?"
"If 5 people all have the winning lottery number and the prize is $2 million, how much will each winner get?"
"If the chance of getting a disease is 10 percent, how many people out of 1,000 will get the disease?"
The respondents were grouped into quartiles according to performance and their mortgage history was examined. What they found was that the worst performers had higher debt-to-income ratios and more than half thought they had a fixed-rate mortgage when it was in fact an adjustible rate mortgage.
So, does free market capitalism break down when large percentages of the population can't make a reasonably informed decision? When giant mortgage lenders like Countrywide can deceive almost every other person that seeks a loan, who will weed out the tires that blow up? When should society, in the form of regulation, step up to prevent business models that prey on the ignorant? Or is taking advantage of the ignorant ok?
I don't have the answers (but I'm always full of opinions ;) ). These questions are just food for thought; another perspective if you will. However, I won't hesitate to proffer that the huge housing bubble may not have been quite so large or 401K's not quite so decimated if seasoned financial advice was sought. Too much borrowing, overextension, and speculation untempered by history and reason are typical red flags for advisors that universally draw warnings. I find it somewhat puzzling that people seek professional help for simple auto issues or turn to lawyers for otherwise simple legal questions, but don't bother to seek advice on the biggest financial decisions in their lives. Why do people find it OK to make horribly uniformed financial decisions, but subcribe to Consumer Reports to figure out which TV to buy? Really, which is more important- buying a TV or making the biggest investment of most people's lives? Of course, as a financial advisor I am biased.
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Even if only a small percentage of consumers are well-informed, that might be enough to tip the scales so that the best companies stay in business. I'd predict that the more well-informed consumers, the faster the best firms rise to the top and the quicker the bad firms fail (I wonder if there's been any economics research on this...).
ReplyDeleteThe "too many dumb consumers will wreck the market" sounds a little bit like the "most mutations are bad, therefore evolution couldn't possibly work" argument Creationists sometimes make.
I'm not sure more informed consumers would have prevented the housing bubble; after all, if the incredibly financially sophisticated Wall Street folks were willing to bet on subprime mortgages, do you really think more financially savvy consumers would have decided "no thanks, that zero-money-down interest-only loan is a bad idea..."?
The real problem is with our current financial system; free-market capitalism doesn't work if firms are treated as "too big to fail."
"do you really think more financially savvy consumers would have decided “no thanks, that zero-money-down interest-only loan is a bad idea…”?"
ReplyDeleteYes. Because they did. I bought a house in 2004. Interest rates were essentially (ignore details) at an all-time low. Why would I ever take an adjustable rate? I took a 30 year fixed. Similarly I just refinanced, at 30 year fixed. Of course my annual interest payment in the next years is higher than on an ARM. But it's still a better decision assuming I do not sell the house any time soon. I am not so sure what a financial advisor would have said at the time, btw, but I am sure we can agree that there are good ones (that lay out the options and the risks) and bad ones (that push for the decision that makes them the most money in the short term).
Which brings me to the overarching thought: I think the problem that carries through all this is short-termism plus a sense of false optimism. Of course, bad math skills do not help, but the "If can save next year, the year afterwards will take care of itself" is just too short. Instant gratification counts more than thinking about "what could happen". That's why nobody pays a premium for a well insulated house with a payback of 5-10 years or even my mother suggests I should take the kids on a nicer vacation instead of saving more money for retirement. That's why students use credit cards to finance a ski vacation. etc.
Both of those - short termism and false optimism - are visible on Wall Street and any other company as well (especially the short-termism). As for rational decision making on Wall street, I don't know. Either AIG (I know, not a bank but a good example) knew the risks they were taking with CDSs for a relatively small profit each year, or they didn't. Both options do not shed a good light on decision making.
I shoulda looked at the data before spouting off-- the financial literacy versus mortgage products study is here (do links work in comments on this blog? I guess I'll find out), and IS very interesting. After a quick look through all the graphs and data, it looks to me like the financially literate people tend to be smarter, richer and college-educated. And more self-motivated and curious (they're much more likely to search the internet for information).
ReplyDeleteI wonder if teaching personal finance in high schools has any effect on financial literacy, or if the unmotivated just daydream their way through it and STILL end up making bad decisions.
And I also wonder how much of this is self-correcting; will people be motivated to learn more about finance after feeling or seeing the pain of the financial crisis?
One explanation for the crisis is that we were suffering from "absurdity bias" -- the inability to consider rare events possible. And that we're now suffering from "availability bias" -- the belief that rare events that have happened recently are common.
Thanks for linking to the study, I meant to do that and forgot.
ReplyDeleteFYI- the only way I know to format comments is to post it, then click edit. Formatting options appear in the editor. Other than that, you have to learn the tags that go in the text to emphasize. You'll see those inserted in the editor.
I remember learning (or maybe it was my own rationalization) that the less-informed consumers basically cancel each other out as their estimates vary widely, both above and below the market price.
ReplyDeleteThe problem is that information isn't always free. Is the cost of obtaining information greater than the savings from using that information? Since Consumer Reports is well-known and cheap, it's no wonder more people use that for decisions than financial advisors.
"the only way I know to format comments is to post it, then click edit"
ReplyDeleteEh - where? no Edit button on my comments that I can see
"do links work in comments on this blog? I guess I’ll find out"
ReplyDeletenot in the form posted - has the blog link, then a slash, then the actual link
I fixed the link. The html needed "http://".
ReplyDeleteNo edit buttons for readers huh? Perhaps I see them as an admin then. I'll try to figure something out so everyone can format better. Will get back to you on that.
I added a cheat sheet for formatting comments. There is now a "formatting tips" page (top right corner of our home page). You can find it here. Let us know if it works.
ReplyDeleteworks. Thanks
ReplyDelete