Free markets and financial literacy
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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