Why You Shouldn’t Fear the Math of Personal Finance
Financial literacy is fundamentally a skill. Numeracy, the ability to understand numbers and perform basic mathematical operations, is also a skill. Higher levels of financial literacy and numeracy correlate with success. Simply put, if you’re more financially literate and have better numeracy skills, you’re more likely to be successful. That said, sometimes fear gets in the way.
Many people have some level of mathematical anxiety, some full arithmophobia — the fear of numbers. But you shouldn’t fear the math of personal finance.
Financial Literacy and Numeracy Correlations
Financial literacy and numeracy are positively correlated. Those who score high in financial literacy also tend to score high in numeracy, and vice versa. Those who score low in financial literacy tend to score low in numeracy. There’s a positive relationship.
Correlation isn’t causation, so we can’t say with great certainty that numeracy causes financial literacy or that financial literacy causes numeracy. We can recognize that they are intertwined, though. It is more difficult to be financially literate if you lack numeracy skills. That’s a very reasonable statement to make. Or, at least, it has been historically.
The Relationship Between Financial Literacy and Numeracy
The existence of a relationship between financial literacy and numeracy should be readily apparent. Financial decisions involve money, and money is quantified numerically. If you’re going to talk about money in the past or money in the future, you’ll need to work mathematically into the past or future — present values and future values.
Even the most basic of financial literacy tools, the budget, requires some level of numeracy. And the most ubiquitous thing in finance, taxes, is steeped in numeracy.
Tools and calculators can simplify calculations, but understanding still requires a degree of numeracy.
The Truth of Financial Numeracy
Financial literacy and ultimately the action of financial planning use numbers to make projections about the future. We then use our projections of the future to make decisions in the present, theoretically creating a better future. And it works.
But the numbers are always wrong. If the best of the best of the financial advisers creates a road map for your future with detailed calculations, the one thing we can say with absolute certainty is that the numbers will be wrong. They won’t be exactly right. Never. We neither need nor expect them to be right.
No one knows the future. No one can say with any great degree of certainty how markets will perform in the coming months, yet we predict them for years. Actually, it’s easier to predict them for years than it is for months.
Numbers seem to be an exact science. Financial planning isn’t.
Financial planning and the use of numbers in personal financial require we get somewhat close. It’s not possible to be right. There are too many variables and too much uncertainty. Things change in our lives and things change in markets. So our numbers are going to be wrong.
We know our numbers will be wrong, so we plan for them to be. It’s safer from a planning perspective to err on the side of conservatism.
Since we know we’re going to be wrong, we under-project our incomes and returns and over-project our costs. We plan on having a successful outcome even though our numbers are wrong because our assumptions were conservative. We know we’re going to fail at making accurate projections, so we fail in a manner that doesn’t negatively impact the outcome.
However, we can’t throw accuracy out the window entirely. We need to be accurate with accounts and with taxes. Those who find that overly challenging can hire competent help. We strive to be as accurate as possible, knowing that accuracy and the future rarely cross paths.
Details vs. Concepts
It’s dangerous to focus on the details at the cost of the concepts. If you need to focus on one, the concepts will serve you better — at least in personal finance.
Take the concept of the time value of money. It’s a universal truth of the financial world upon which many projections and assumptions are based. The concept is that a fixed sum of money is worth more in the present than it is in the future.
The reason is that if you have a sum of money in the present, you can earn a return and have a greater sum in the future. As a result, the sum in the present is worth more than an equal sum would be in the future.
The details are the mathematics. The details say that the future value of a present sum is the present sum times one, plus the rate of return raised to the number of periods out into the future. My guess is that most practitioners would recognize that formula when presented with it, but that very few could produce it off of the top of their heads.
Practically, we know that future values, the spend-ability of future dollars, is eroded by inflation. Real returns are returns to the extent they exceed inflation. Simply, we’re better off investing. Our spend-ability improves to the extent our returns are greater than the amount of inflation.
If we want to do well financially, we need to understand the time value of money more than we need to understand any other numeric concept. However, we don’t need to know the formulas. It’s all about the concepts.
The Realm of the Fears
I have often heard statements such as “I’m just not good with numbers.” Actually, none of us are born good with numbers.
Some people learn numeracy more easily than others do, but it’s a skill. It’s learnable.
You don’t need to solve higher order differential equations. Financial literacy, mathematically, can be accomplished with some addition, subtraction, and calculators. Conceptually, you should know what the calculators you’re using are doing. Mathematically, it’s not necessary or even really beneficial.
Most of us know fear more personally than academically. Phobias and anxieties can be treated or improved through professional help. That’s the correct avenue for some people. Others may be able to deal with their fears directly.
Understanding our fears empowers us to overcome them. Fears are universal, everyone has them, some are just afraid to admit it. My experience is that facing fear is our greatest weapon. When we face fear we often find that there was no real basis for the fear. Numbers don’t bite.
The Bottom Line on the Math of Personal Finance
Understanding the concepts leads to success. All too often, getting mired in the details leads to the inaction — the overanalysis-paralysis chain. Getting better at financial literacy will absolutely help to improve your financial future. Getting better at numeracy may help make that easier. But the starting point is not fearing numeracy.
The concepts are what make the difference. People use the concepts they understand, whether they understand the mathematics or not. Relax, you don’t need to be a mathematician to deal with personal finance. Besides, numbers really don’t bite.