10 Truths about Smart Financial Decision Making

High school students are passionate about financial education. The demand for our Wharton Global Youth on-campus Essentials of Finance program prompted us to create a new online program for high school students this summer that we are calling Financial Decision Making.

Students’ passion extends to spreading that financial knowledge. Our team often receives pitches from potential Future of the Business World podcast guests about teens’ efforts to improve youth financial skills and fight economic inequality across the globe.

Take, for instance, Isaac H., a high school student from rural Indiana in the U.S. Isaac founded Students Teaching Finance, a student-led nonprofit that teaches personal finance to K-8 kids. We’ve also met Amanda L. B., founder of The Financial Girl, which specializes in teaching teens about personal finance in public schools across Puerto Rico. And we featured Sam P. on our podcast, a high school student from Vancouver, Ontario, Canada who founded MyFLY to build and implement a financial-education curriculum in schools worldwide.

Making Smart Financial Decisions

We could add more names to our podcast pitch list! But instead, let’s pivot to meet a decades-long expert in the financial-education field. Olivia S. Mitchell, a professor of business economics and public policy at the Wharton School of the University of Pennsylvania for the past 30 years, is a leader in financial literacy, which she defines as “the knowledge and the capability to act on financial, economic principles.”

Dr. Mitchell joined Wharton Global Youth’s summer cross-program speaker series to talk about financial literacy to several hundred high school students participating in our on-campus summer programs. “I have been passionate about financial literacy for a long time,” she told them. “I believe it’s critical as members of an educated society to have the tools and the understanding of financial risk management.”

Here are 10 truths about financial decision making that Professor Mitchell shared with Wharton Global Youth students:

1️⃣ Risk management of any kind involves three steps: Identify the risk so you know what you’re facing; mitigate or reduce the risk; and finance or insure the risk. “You’ve got to make sure you are protected by amassing enough money,” noted Dr. Mitchell. “If you become unemployed, you should have six months of savings to draw on. And with insuring, you put some money into a risk pool. Buy insurance against poor health and disability. For example, if you own a home, you [buy insurance] because you want to make sure that if it burns down, you have some compensation.”

2️⃣ People get into financial trouble for many reasons, deepened by the fact that they undersave and/or overspend. They face health shocks like a disability that might leave them without income for many years, or they become unexpectedly unemployed. And more people are living much later in life. All these factors can throw people into financial crisis.

3️⃣ Financial literacy is an important part of risk mitigation. Said Professor Mitchell: “If you are financially literate, you’re going to plan better, budget better, save more, and when the time comes to retire, you’re going to pull out the right amount of money — and not too much” that you then have a shortfall when you get older.

4️⃣ More than 15 years ago, Professor Mitchell and a colleague devised three key questions to determine financial literacy (see box). “There are a lot more [financial] concepts, but if you can’t answer these three questions, you’re in big trouble,” said Dr. Mitchell. (Find the answers in the comment section of this article).

5️⃣ Financial illiteracy is a global challenge – with opportunity for growth in financial education. (see graph). Why is China less financially literate? “There’s a huge rural population in China,” observed Dr. Mitchell. “And even in the urban areas, they still only have nine years of mandatory education and kids just don’t get exposed to financial decision making.”

6️⃣ How long do you need to think about managing your money? Average life expectancy is 77 or 78 years in the U.S. and longer in other countries, like Japan. “There’s been an enormous expansion of our lifetime, which means there are a lot more years for you to make financial mistakes or to apply your financial literacy,” noted Dr. Mitchell. Babies born today will live to 100 or beyond. And demographers say that a baby has already been born who will live to 200. “You should plan for it because if you don’t, what will happen? You’ll run out of money,” cautioned Mitchell.

7️⃣ Understand retirement investment allocations. Whatever you put into [a retirement] plan and decide to save; what you earn on that money while it’s invested; and what you might earn from an employer matching plan is what you will have for retirement later in life. “This is where financial literacy becomes critical,” urged Professor Mitchell. “If you don’t understand the lifespan that you’re going to be saving and investing for, if you don’t understand risk and risk mitigation, and if you don’t understand the danger of outliving your money, you’re going to make all those decisions wrong.”

8️⃣ When it comes to retirement savings, the earlier, the better. When your financial advisor gives you a rule of thumb or your employer says that people on average should save 3% of your income for retirement, don’t believe them, suggested Dr. Mitchell. You should be saving 20% to 25% of your income.  “If you assume Social Security will pay you a 50% replacement rate – replace about half of your pre-retirement income – then you will have to come up with the rest of the income stream by saving on your own,” she said. “If you start at 25 for retirement at 65, with an expected rate of return [on your money] of 3%, you will need to save 11.11% of your income. If you waited until you were 20 years from retirement because you had to pay back your student loans…and didn’t have a lot of available income to save, you would have to save more than a quarter of your income for retirement.”

9️⃣ An expected long-term rate of return of 3% is a good scenario. Economists predict that the rate may fall in the future. “Population aging and the decline in fertility means that worker productivity will not increase enough to keep rates of return high. Then maybe what you’re going to get is a 1% long-term rate of return.” That will require you to save even more for retirement.

🔟 Dr. Mitchell predicts that our financial health depends on bolstering family and individual financial literacy; saving more money, working longer and insuring better; reforming banks, pensions and Social Security; and developing new risk-financing tools.

Conversation Starters

Are you passionate about financial education? Share your story in the comment section of this article.

What are your biggest takeaways from Professor Mitchell’s lecture? Has this inspired you to better manage your financial risk?

Why is financial literacy an important part of risk mitigation?