Olivia S. Mitchell is a professor of insurance and risk management at the Wharton School. Mitchell believes in the power of financial knowledge to help people plan and to make smart financial choices for their future, whether that means saving for a new car or socking money away for the day they retire. Knowledge@Wharton High School talked with Mitchell about learning to save effectively, use credit cards wisely and know when not to spend.
An edited transcript of the conversation follows:
Knowledge@Wharton High School: What is financial literacy, and why is it important for students to understand it?
Olivia Mitchell: My studies are centered on an area called financial literacy, economic literacy. This has to do with the knowledge that people have of the world around them – the mathematics of economy. In other words, how do you save, how do interest rates develop, that type of thing. It is some mathematical knowledge, but also knowledge about the financial world.
KWHS: In all of this, what would be the most basic knowledge?
Mitchell: There are two types of literacy that are important. One has to do with fundamental concepts and the other has to do with financial institutions. First, let’s focus on fundamental concepts. What matters most is some arithmetic ability. For example, we ask, ‘If there are five people who have won the lottery and they have to divide $2 million among themselves equally, what is the total that each will receive?’ We see that in every country many people cannot give a correct answer to this very basic problem.
The other question we ask concerns inflation. Let’s say the inflation rate is at 2%, and you can count on an interest rate of 1%. After a year, does one have the same [amount of money] more or less with which to purchase things? Many people do not comprehend inflation. And the last [question] that is also perhaps the most important of all has to do with compounded interest. In other words, if you save [money], then every year you continue to save on top of the savings of the previous year — the total base keeps on growing. Many people do not understand that. Those are the three most fundamental questions regarding these [financial] concepts. Also in every country, there are financial institutions like banks, pension systems, etc. That is also very important for people [to understand] in order to know how they can save effectively.
KWHS: What can you recommend to a young person in high school or college about saving? Why is it important to start saving at a young age?
Mitchell: Saving is not very easy for many people. First of all, it takes effort. You have to decide not to consume today and to defer that consumption to the future. It is not very natural and it is not very easy for many people, especially young people, when they have many desires and very little money. It is important to try to describe the objectives of saving.
You [may] want to save to buy a motorcycle or a car, and after some time perhaps a house, also keeping in mind that after 30 or 40 years of work, you are going to have to retire. All those are objectives — goals to keep in mind so that you may begin saving now. It is much easier to begin now, year by year, than to do it all at once at the age of 60. At that point, you don’t have much time, and it will be much more difficult.
KWHS: In terms of credit cards – what is the right way and what is the wrong way to use them? What are the risks of credit cards?
Mitchell: When my daughter began her studies here at Wharton, she was given a credit card. After very little time she was already behind and paying very high interest rates. I told her that it is better to cut it up, pay it off and begin again. The majority of young people do not understand that [a credit card] has to be paid off entirely every month. You cannot pay only the minimum and let the debt grow and grow. It is very important to establish a clean credit history.
KWHS: When you were 18, do you remember what you did with your money? Did you take risks or did you save?
Mitchell: Like many people, when I was 18, I was in college and I did not have a lot of money, so I did not have much. But I was always trying to at least work some, pay my bills and not be late [paying off] my credit card. Most of all, [I tried to] consume as little as possible. I have tried to do that my whole life — always buy less than I could so that I end up saving something.