The Job of Understanding Money

Jihyun Kim | June 6, 2021

Note: Nothing in this article constitutes financial advice.

Young people today are the best educated generation in history; we were told that studying hard, going to college, getting a good job and maybe even loving work will assure a good life. But does this advice work? This pandemic had all of us, and specifically those entering the job market in a recession, in for a rude awakening: hard work and perseverance are no longer enough. What worked for our parents’ generation to achieve upward social mobility on the backbone of the economic boom is certainly not working for us. We are learning the hard way that education gets us a lot but not enough, and especially not financial security.

Money, after all, is emotionally charged, unfair and uncomfortable to talk about. Why do we work and why do we save money in the first place? There are many financial goals, but ultimately we earn and save to achieve security that can fulfill all of our hierarchy of needs. Most importantly, we work now to save enough for the distant future when we can stop working, which we call retirement. When many young people are struggling with student loans and rental prices, let alone the omnipresent stimulation for consumption, it’s hard to think about 50 years down the line, let alone 5. Yet planning for financial security and retirement early is critical precisely because we have the most control over which paths we set ourselves on early in our lives and because retiring in 40 years will look very different from retiring today.

For one, our generation will not be able to retire at the same age as our parents. Life expectancies in many countries are increasing (some heading towards 90 years) which is a great indicator of public health but not so much so for pension systems. When combined with low birth rates, plunging interest rates and little economic growth, longevity becomes a problem; many national and employer-sponsored pension systems around the world. For example, the size of the world’s collective retirement savings gap could exceed $400 trillion by 2050, up from $70 trillion in 2015, according to this World Economic Forum report.

Figure 1. The expanding retirement savings gap (Bloomberg)

Pensions are also disappearing from employment benefits all together. There are two types of retirement plans: defined benefit plan and defined contribution plan. Defined benefit plans (DB) pay eligible employees a guaranteed income for life after retirement while defined contribution plans (DC) are funded primarily by the employee while some employers make matching contributions in national schemes such as 401(K) in the US, CPF in Singapore, Super in Australia and NPS in India. DBs are still common for public sector jobs but have largely disappeared from the private sector as employers have switched to DC.

The key differences between DC and DB decides whether the employer or the employee bears the financial risks. By deferring the administration and distribution of pension funds to the government and the employee, DC plans free the employer of the unknowns, such as investing the money properly, how long the pension will last or the employee would live. The burden and insecurity of financing one’s retirement is increasingly placed on the young. However, due to contributions being optional, lack of awareness and more frequent job changes, 95% of millennials are falling short of saving enough for retirement.

Home ownership is a critical part of planning for retirement, but this too is not any easier for this generation, especially in cities where good jobs are most abundant. Given no real income growth despite accelerating housing prices in many urban areas, buying a house with salary alone is becoming more difficult every year. According to Urban Institute, the millennial homeownership rate in the U.S is 7%-7.2% lower than the homeownership rate among previous generations when they were ages 18 to 34. More education debt, high rental payments, and low income growth prevent young people from saving enough for an emergency fund, let alone a down payment.

Then there is the climate crisis (and it’s a crisis, not a change), which is an impending threat to our lives in the next decade, let alone the next few. The future uncertainties of the effects from the climate crisis, especially when Earth warms beyond 1.5 degrees, affect our security in both the physical and financial realms. For example, in 2020, there has been a record of 22 billion-dollar weather and climate disaster events in the United States. This is a sharp increase from the 1980–2020 annual average of 7.1 events (CPI-adjusted). The increasingly frequent climate disasters will quickly rack up the emergency spendings across government, corporations and insurance companies while financial markets may take more frequent hits too. Not only will the catastrophes steal from our retirement savings, they will also threaten our future retirement habitats with less arable land, access to clean water and outdoor livability.

All of this is overwhelming; the cards stacked against us are systematic and generational. Before we let this anxiety debilitate us, however, we should first discern and call out the policy-level failures that removed safety nets for young people, especially when the blame wrongly points to the individuals and avocado toasts. The failure to provide affordable housing, control housing prices, ensure sufficient income and job growth and take timely actions against climate crisis are on the individuals to bear the burden of yet we do bear it now. So if ignorance and inaction are not the answer, what can young people do today to take control?

One step is financial literacy, and we have a lot of work to do. While we may be the most educated generation, we are definitely not the most financially educated. A recent study by OECD found that on average across G20 countries, fewer than half of adults (48%) could answer 70% of financial knowledge questions correctly. Young people (aged 18-29) appeared to have lower financial literacy and financial attitude scores than the rest of the sample consistently and significantly. They also tend to have lower financial knowledge and less prudent financial behaviour, and although educational attainment is positively correlated with financial literacy, the well-educated are not necessarily savvy about money. In fact, a study found that schooling is only positively associated with wealth accumulation when interacted with financial literacy.

Financial ignorance carries significant costs. Individuals who fail to understand the concept of interest compounding spend more on transaction fees, have bigger debts, and pay higher interest rates on loans. They also end up borrowing more and saving less money. Meanwhile, financial literacy enables wealth accumulation. People with strong financial skills are much more likely to plan for retirement and are also more likely to diversify their portfolios when investing, a key factor in managing risk and achieving better returns.

Most importantly, financial literacy helps us discern how to best use and protect ourselves from new financial technology, so called fintech services, that we use everyday. Rapid developments in fintech have enabled billions with unprecedented access to financial services like opening a bank account, making payments, getting loans and trading stocks and cryptocurrencies. Covid pandemic has especially accelerated this fintech adoption; this study from Swiss Finance Institute found that the spread of COVID-19 and related government lockdowns have led to 24%-32% increase in the relative rate of daily downloads of finance mobile applications in 74 countries.

Last year, bored and hopeless with Covid stimulus checks, many people turned to trading apps like Robinhood, Interactive Brokers and Freetrade to bet on quick and easy wins from meme stocks like GameStop by browsing Reddit and Youtube tutorials. Many of the trading platforms, commission-free, fun and easy to use, often market a mission to “democratize finance.”

The apps have indeed opened doors to many retail investors to trade complex and risky financial products that were previously only allowed on Wall Street. Increased access is good for financial inclusion but it can also be detrimental when granted without proper education.

Studies after studies have shown that active trading reliably leads to negative returns, even for professionals. The more often small investors trade stocks, the worse their returns are likely to be, and even worse when using Options. But many novice retail investors users fail to understand that trading is not investing. More than at any other retail brokerage firm, Robinhood’s users apparently trade the riskiest products and at the fastest pace, according to an analysis by The New York Times.

These brokerage apps make money when users trade often and in large volumes, not necessarily when the users make a profit. The app is now coming under regulators’ scrutiny for encouraging speculation and “continuous and repetitive use” by design. A recent study on Robinhood trading data showed that returns are worse for users who may rely on the app’s attention-inducing features like stock rankings. Data showed that if users bought Robinhood’s top 10 newly purchased stocks, they would have 5%-9% less returns than the S&P 500 index in the next month. The authors added that “large increases in Robinhood users are often accompanied by large price spikes and are followed by reliably negative returns.” The herd of inexperienced investors have little data to make trading decisions with, so they are biased towards the most visible information on the app and thus end up trading “more aggressively than other retail investors.”

Figure 2. Robinhood's revenue streams (The Fintech Blueprint)

During the past decade of Big Tech dominance, we’ve learned the hard way that when we are not paying for the product, we are probably the product. A recent SEC filing showed that in Q1 of 2020, Robinhood’s controversial business model, despite being commission-free, has generated almost $100 million from Citadel Securities and the other market makers, who make profit from both price volatility and volume of stocks. This practice, so called payment for order flow (PFOF), is illegal in many countries including Canada and the U.K.

We have paid hefty prices, including the loss of data control, because we did not question Big Tech on their business models and how they align with the users’ interests. What is at stake when inexperienced and young investors are trading high risk stocks and derivatives with borrowed money is exceptionally costly. The devastating effect of trading mistakes leading to massive debt is already evident and tangible, disproportionately affecting those who are less financially resilient.

More access can be good, but it has to be paired with sufficient financial literacy. To start, we need to understand two important concepts: compounding interest and diversification. Whether it is value investingan investment paradigm that involves buying securities that appear underpriced or index investingan investing strategy designed to match a market, not beat it, there have been plenty of studies that confirm that diversified, low-fees and passive investments do generally well in the long run. Higher costs in some mutual funds or Investment-Linked Policies (ILP), on the other hand, are some of the most proven predictors of poor returns.

We also need to understand the time value of money -- the quantifiable opportunity cost of ignorance and inaction. For example, S&P 500, a stock market index that tracks 500 publicly traded U.S. companies, returned 18.4% in 2020 and 31.49% in 2019. To illustrate, if one put $1,000 in S&P 500 in January 2019, that money would now be worth $1,607 as of April 2021 (you can try simulating using this calculator). Simply tracking the market index of diversified assets can be a good enough strategy for long-term wealth accumulation, and even better than 85% of large cap active fund managers. Furthermore, the global inflation rate is around 3%-3.5%, which means that putting money in bank deposits or others with less returns than inflation means that one is losing money and purchasing power everyday.

Figure 3. Tracking the market most often outperforms active investment (AEI)

When our retirement plans are increasingly threatened by the climate crisis, it is paramount that the money we save for the future works for the future. Environmental, Social, and Governance (ESG) and sustainable investing involves directing money to companies with a positive impact, as measured by non-financial factors. It is a more holistic way of investing that prioritizes not only shareholders but also stakeholders, and it has also shown to provide better returns. ESG investing alone is nowhere enough to achieve a net-zero future, even with major policy change. It is also a new field with much room for improvement but it offers hope in the right direction.

After learning basic principles of investing such as diversification and compounding, we should then decide on what the optimal asset allocation is given one’s age, risk tolerance and timeline. Alternatively, we can use digital wealth platforms and robo-advisors to make this process easier, automated and at low fees. Robo-advisors are different from trading apps in that they take a long-term, often passive investing approach. They invest on the users’ behalf in diversified, risk-adjusted portfolios using algorithms and/or human advice. They can be helpful in assessing what portfolios suit one’s age and risk tolerance and automatically rebalancing the weights when markets fluctuate. Until recently, private banking and wealth advice has been an exclusive service only available to the ultra rich. Now with technology it’s been made cheap and scalable to the masses as a way to lessen the burden for the individual to worry about the end to end investing lifecycle.

Financial literacy is the first step in protecting our social security against the systematic odds of retirement, housing and climate crises that loom our future. We may be burdened with more financial responsibilities and uncertainties than the previous generation, but we also have unparalleled access to information and fintech services. We can use technology in a net positive way and when it doesn’t serve us, we have the means to create an alternative.

At the same time, financial literacy can serve as the basis for us to discern what is working versus what is not, and which burden lies on the individual versus the policymakers. To challenge the system-wide problems, we need to know how to differentiate what hard work can attain versus what it never can. Young people cannot afford housing in urban areas not because we don’t work hard enough but because housing prices accelerate faster than real income. We aren’t having children not because we are self-centered but because it seems ethically wrong to bring them into a world with such a bleak future.

Post-pandemic, the financial anxiety of our generation is real, as manifested by Gamestop and crypto investing frenzies. Yet we don’t see enough being done by those currently in power and older (OK boomer) to lessen the economic and environmental bill that we are left with to pick up. Whether with our tech platforms or economic systems, we deserve a better deal, one we can demand when we understand money.

We believe in furthering the conversation on finances beyond this article. Here are a few resources from Jihyun to get that started:

1. A New Deal for the Young | The Financial Times

2. Investing 101 | Nerdwallet

3. How to avoid losing all your money on investing apps | Vox

4. Life skills: personal finance | Khan Academy

5. Robinhood Has Lured Young Traders, Sometimes with Devastating Results | The New York Times