Sunday, March 24, 2013

Wealth and Motivations for Saving

In a recent column in the Atlantic called "Building the Wealth of the Poor and Middle Class," Noah Smith suggests a few ways to improve the unequal distribution of wealth in America. He notes that "one obvious thing we could do to make wealth more equal is - surprise! -redistribution...Giving the poor and middle-class more income will boost the amount they are able to save, the percentage they are willing to save, and the return they get on those savings. Part of the reason America's wealth distribution is so unequal in the first place is that our income distribution is very unequal." But he adds (emphasis added):
There are reasons to believe that redistribution can't fix all of the problem, or even most of it. If you do the math, you discover that in the long run, income levels and initial wealth...are not the main determinants of wealth. They are dwarfed by...savings rates and rates of return. The most potent way to get more wealth to the poor and middle-class is to get these people to save more of their income, and to invest in assets with higher average rates of return...In addition to "nudging" middle-class and poor Americans to save more, we can help them get a better return on their assets -- the second thing that has a huge effect on wealth in the long run.
I think there is good reason to believe that a lot of people don't understand the importance of getting a good return on their assets. I am working with the Dutch National Bank Household Survey data in my research, and some of the survey questions have to do with motivations for saving. About 2000 households take the survey. In one question they are asked  to rate how important it is "To save so that I generate income from interests or dividends" on a scale from 1 to 7, with 1 being "very unimportant" and 7 being "very important." They can also choose "not applicable."

In 2012, the most common response to this question was 1, that is, that generating return is a very unimportant consideration in household's saving behavior. Two other questions ask how important it is to save "so that I have some extra money to spend when I'm retired" and "to cover unforeseen expenses." The most common answer to both of these questions was 6, with most respondents choosing 5, 6, or 7. In short, even though most respondents understand some reasons for saving, they do not see much importance of saving to earn interests or dividends. This data is from Dutch households, but American households are probably similar: many people likely do not realize the power of compound interest or understand how getting a good return on assets has a huge impact on wealth in the long run.

In the chart below, I plot responses to the question about the importance of saving to generate income from interests or dividends in 2012, grouped by people without and with a university education. The university-educated group rates this as somewhat more important. Respondents are also asked to self-report their level of financial knowledge. In the second graph I plot the fraction of people who respond 5, 6, or 7 by self-reported financial knowledge. Only 16% of people who say they are "not knowledgeable" think that saving to generate income from interests or dividends is important or very important, compared to 39% of "very knowledgeable" people.



I think this lends some support, however tentative, to Noah Smith's proposal to teach the public more about how wealth builds over time and why it is important to get a good rate of return. If people don't really grasp the importance of earning interest, then they are not very likely to make an effort to get a good return, which doesn't bode well for their future wealth. And knowledge does seem to help.

11 comments:

Richard H. Serlin said...

I agree. Below is a link to an assignment/article I've used in my personal finance I course at the University of Arizona since 2005, and I cover this in many other places, including assigning Elizabeth Warren's book, "All Your Worth" cover to cover, by far the best today.

http://works.bepress.com/richard_serlin/13/

Richard Hancock said...

Perhaps people misunderstood the question? Did anyone ask them what they understood the question to be asking? Or perhaps you're misunderstanding the question to be asking about return on investment? (Or perhaps the English version is a poor translation, e.g. "interests" (sic), of the original Danish?)

To me, "To save so that I generate income from interests [sic] or dividends" would be understood as "I need to generate an income from my savings". So people who want "[interest] or dividends" to accumulate might answer "no" (i.e. a response of 1 on the scale of 1 to 7) to the question.

The more I think about it, the more I think you've misunderstood the question to be asking about return on investment, when in fact it is asking if savers need to draw a current income (e.g. interest/dividends) from their savings/investments.

Claudia said...

A few thoughts. I do think basic financial literacy, such as an understanding of compound interest (on asset or debt side), would be beneficial to many. Not sure it would boost saving but might reduce debt (raising net worth). I disagree with Noah that asset allocation is that first order concern, higher saving rates, which are easy with steadily rising, not stagnating income are the key. Finally, I should note if you have a fairly flat income path over your lifetime incl. OASDI then you may not want to save much. More is not always optimal given the institutions and other constraints on people. Wealth is deferred consumption...not everyone is best served by deferring.

veryshuai said...

Another stata user...

Noni Mausa said...

Am I the only one asking how people are supposed to save when their income is less than cost of living? And how they can invest in the face of less than 0% return on savings (after inflation) and a systemically unreliable investment and banking industry? You can't get traction on a glass mountain. Mandating money handling classes for students and the poor is useless at best, and infuriating to those who see the whole landscape.

Richard H. Serlin said...

"saving to generate income from interests or dividends"

But, you do have to think carefully about how people are interpreting the question, or misinterpreting it. They may be thinking something very different than what you think. The wording can be so important.

Here, they may think that I'm not saving so that I can be rich and not have to work; that's not realistic for me, and too much sacrifice. I'm just saving for retirement and to cover unforeseen circumstances, emergencies (as they said). But still, I do understand that I'll save for retirement a lot better if I have a lot higher return. I do understand that that's important.

From my experience, though, what most people don't understand is that a higher return rate makes a much bigger difference, that twice the return will result in far more than twice the money over the long run, that it's very non-linear, very exponential. What they don't understand is just how massively powerful is exponential growth over long periods at an interest rate like the stock markets historic average, almost 7% real.

And they don't understand just how much higher an average return the stock market has, and how to invest well as a layperson in general -- highly diversified index stock fund for very long run, paying off your home quicker, and not overspending on your home, CDs for shorter run, etc.

I spend a lot of time teaching all of this, as you can see from the assignment I linked to -- It's especially beneficial to learn this when you're very young, like a 19 year old undergrad, or younger.

But again, be careful of your interpretation of their interpretation of the question. Focus groups can be nice to find out how they really interpret questions.

Richard H. Serlin said...

Ok, actually re-reading your post more slowly, I see you are interpreting things largely like I was.

There may be the thinking that I'm not trying to get so rich I can live off of the return to my fortune, I just want to be able to retire comfortably and have money for emergencies. But this kind of attitude may come from not realizing how powerful a strong compound return is with something like stocks for the long run, and how you can really realistically strongly supplement your labor or Social Security earnings with just the returns on your savings if you start early.

RebelEconomist said...

Perhaps many have suspected that the historic returns on savings in stocks etc are unsustainable. They reflect a period where central banks etc have bent over backwards to sustain the prices of risky assets. This is certainly what has kept me in relatively conservative assets, but I must admit, I have been infuriated by the authorities' willingness to resort to all manner of previously almost unimaginable debauchery (abandoned inflation targets, QE, even the "help-to-buy scheme in the latest UK Budget etc). The stakes keep getting bigger.

doc said...

It seems to me that there's an additional issue that't not being addressed: Risk, and in particular the risk of capital loss. People may recognize that there is, in fact, a trade-off between risk of capital loss and current return on investments/saving. So maybe their behavior is more rational than it appears, unless we know about their willingness to assume risk.

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Steve Roth said...

Hey don't have time for a long comment, just to say that this JW Mason paper is very much to the point:

http://repec.umb.edu/RePEc/files/FisherDynamics.pdf