Ignorance is no excuse for temporary bliss

Admitting a bit of ignorance when it comes to the management of your finances will likely benefit you in the long term.

cartoon for personal finance october 9th
Gary Clement for The National
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It is a staple of cop shows: the tough-talking detective gets the suspect alone in a dimly lit interrogation room, gets in his face, and snarls: "We can do this the easy way - or we can do this the hard way". When it comes to our money, consumers have a similar choice.

And the ugly truth is that many of us choose the hard way - buying things on credit we know we can't afford, making rash decisions without any research and putting off saving until that blissful point in the future when it is convenient and there is no vehicle, garment or gizmo that would be a more enjoyable use of our hard-earned money.

We are not all masochists, savouring the pain we are deliberately inflicting on ourselves. We usually just do not recognise the long-term consequences of our financial decisions. I know I didn't when I was younger. That, in a nutshell, is the virtue of financial literacy. It helps us to understand how the choices we make now will affect the quality of our lives down the road, often in ways that are not immediately obvious.

It is hard to deny that financial literacy is embarrassingly square, the equivalent of hectoring children to eat their broccoli and cauliflower. And in a region where conspicuous consumption is the rule and not the exception, it can be an especially hard sell. But the financial crisis taught us that consumers are faced with choices every day that come with drastic results. Just ask one of the millions of Americans whose homes are in foreclosure because they did not understand the terms of the mortgages they accepted, or the Dubai investors who own nothing more than a receipt for a flat in a glitzy development that may someday get built.

Many of us have heard stories of people in the UAE who either fled the country or spent time in jail because of credit-card or other personal debts. Do you think all of those people understood the potential penalties when they signed the dotted line? My guess is that they thought they did. There have been studies showing that the less people know, the more overconfident they are. In one quiz, out of Germany, the researchers found that 80 per cent of those surveyed said they were confident of their answers, but only 42 per cent got more than half of the questions right.

We often do not recognise our own ignorance (academics have a name for this - the Dunning-Kruger effect), at our own peril. Sure, most of us know that credit-card debt can be dangerous, but many consumers also think they are doing enough to avoid problems if they simply pay the minimum amount due each month. In fact, that is a sure route to massive debt. Or consider that a recent survey showed that more than one in five Americans utilised "non-traditional lenders" such as pawn shops, payday loan stores and tax-refund advances. The main thing these outfits have in common is that they charge outrageous fees in exchange for short-term cash.

Making matters worse is the growing complexity of financial products that consumers have to choose from. More choice is hardly a bad thing, just as the gimmicky mortgages that got so many Americans in trouble are not inherently evil, but the multitude of new options simply requires more due diligence. When my parents were buying their first home, there was one mortgage product available - a 30-year fixed-rate loan.Today, you can choose the length of the loan, go for a variable rate, a second loan on top of that and even opt to only pay the interest for the initial few years.

In that era, too, most workers retired with a pension that required little more effort than retrieving the cheque from the mailbox each month. Today, most workers have to commit to setting aside a portion of each paycheque, choose an asset allocation, monitor the tax implications and decide on an effective withdrawal strategy. The burden has shifted dramatically to the consumer to determine how best to invest.

In the UAE, many of the complaints voiced by consumers are based on the fact that the financial services industry is still relatively young. As it develops, more sophisticated and nuanced products will be offered by banks and investment houses. Consumers will bear even more of the burden to make difficult decisions, not less. As my colleague Jeffrey Todd points out in this issue, the financial crisis has prompted many countries to ramp up their financial literacy programmes. This trend is a positive step - you could argue that a few fellas in the corner suites could benefit from sitting in on a few sessions as well.

One of the leading experts in the field, Annamaria Lusardi of the Financial Literacy Center in the US, has said she thinks it is a good idea to make people get a licence demonstrating some degree of financial proficiency before getting a mortgage. It is less ridiculous than it sounds on first blush. I think the most helpful tip a financial literacy instructor could teach students would be how to stop a banker, mortgage broker or investment adviser and say: "Wait a minute. I don't understand exactly how this works." It is sometimes hard to admit we do not fully grasp every detail of how our money is saved, spent and invested, but confessing to a little ignorance from time to time can be the smartest move you can make.