It’s widely documented that there is a lack of financial literacy among U.S. adults. FINRA’s State of U.S. Financial Capability study found that only 34% of individuals can correctly answer 4 or more questions on a basic 5-question financial quiz.
And Americans want help. Northwestern Mutual found that 6 out of 10 Americans say their financial planning needs improvement.
As a result, many in the industry are focused on the question of how to help increase financial literacy in this country. Despite the great efforts in this space, individuals are seemingly still resistant to taking the time to learn more about finance.
Flipping the Financial Literacy Question
We want to flip the question: How can we make it easier for people to engage with financial problems while avoiding the need to increase their financial literacy?
We wrote a post that examines this new question and lays out what we believe to be a path for individuals to engage with financial problems without the need to increase financial literacy: tacit knowledge.
Tacit knowledge refers to knowledge that is intuitive and rooted in context, experience, practice and values. It is often unspoken as it is gained through experience that can be difficult to put into words.
The skill of leadership and the ability to walk are both examples of tacit knowledge. They are skills that have been gained, but without explicit, documented instructions for how to acquire them.
We believe that tacit knowledge can also play a role in financial literacy. Specifically, we think that there is a way to help people gain a tacit understanding of how to build a financial plan.
How? We believe there are three fundamental components to unlocking tacit knowledge of any subject: imitation, practice and analogy.
The First Two Components to Unlock Tacit Knowledge
The basic toolkit to acquire tacit knowledge of any subject starts with imitation and practice. Most of us learn how to throw a baseball by… throwing a baseball. We watch others throw a baseball, imitate them, and then practice until we are proficient.
You could have gone about learning to throw a baseball by examining the explicit problem: How to move a spinning spherical mass (a baseball) through a medium (like air) using angular velocity (your arm, rotating on your shoulder), all while subject to a gravitational field.
No one immediately knows how to solve that problem, nor would you start out by approaching it this way. Yet, you still somehow learned and now understand how to throw a baseball.
This is because you have a tacit understanding of the action, which you developed, first and foremost, through imitation and practice.
You imitated someone else performing the action. Then you continued to practice that action until you were successfully able to throw a baseball.
But how does this apply to finance? Well, you can gain a good understanding of some financial concepts just using this basic toolkit.
For example, budgeting. You can imitate how a friend or family member sets up their budget and practice until you’re proficient in setting one for yourself.
But are both imitation and practice sufficient to develop a tacit knowledge of financial planning? Unfortunately, no. Let’s understand why.
The Need for Financial Investment Literacy
A critical component of a financial plan is the portfolio. Therefore, to create financial plans, we need financial investment literacy.
Why is investment literacy more complicated than other types of financial literacy? Well, it relies on more complicated math – specifically, powers of numbers – that very few of us could gain an understanding of using just imitation and practice.
The magnitudes and sensitivities of powers make it difficult to acquire a tacit understanding of them. For example, if we want to know how much a $100,000 investment will grow over 20 years, at say, 6% a year. One needs to use powers to solve this problem (multiply $100,000 by 1.06 ^ 20). Very few people can do that calculation in their head.
Thus, imitation and practice are not a sufficient toolkit to acquire tacit knowledge of financial planning.
No matter how much we practice or imitate, we likely won’t be able to develop the tacit understanding of powers that, in turn, is needed to develop a tacit understanding of investment literacy.
Can we add something to the toolkit of imitation and practice that would allow us to acquire a tacit knowledge of investment literacy, and thus financial planning? We think the answer is yes.
The Final Tool in the Toolkit: Analogy
The third ingredient that we can add to the toolkit is analogy. Analogy is the process of learning about one object by comparing it to another object you already know.
For example, if someone asked you what alligator tail tastes like, you likely would have no idea. But, if they told you that alligator tail tastes like chicken, then you would have a tacit understanding of what to expect upon eating an alligator tail.
In that case, you would have used your knowledge of chicken to understand a new food you’d never encountered – alligator tail.
Analogy can be used in lots of contexts to acquire new skills. You could use your knowledge of skateboarding to pick up surfing or your understanding of how water flows through a pipe to learn the biology concepts of how blood flows through veins.
It can also be used in the context of financial planning. Here’s how.
There may be some aspects of a financial plan that you understand – what it means to save more or to wait longer to reach a goal. And there may also be some aspects that you don’t – what it means to choose one investment option over another or to put your extra savings toward one goal versus another.
If you can translate your understanding of one aspect of a financial plan, like time, into another aspect that is less understood, like a portfolio, then you will have used analogy to unlock your ability to plan.
We think that all aspects of a financial plan can be translated into a common language that would let people easily compare one aspect of the plan to another. Or alternatively, assess whether one action – like saving more – is better than another – like investing differently.
We’ll write more about how you can do this translation in a future post, but for now, you have the complete toolkit for developing a tacit knowledge of financial planning. Imitation, practice and analogy.
Analogy unlocks the ability to interact with all aspects of a financial plan, even those you don’t understand. Then, you can use imitation and practice to engage with your plans and experiment until you develop one that works best for you.
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