Teaching Kids about Financial Risk

Last year a Chicago teacher’s response to a survey on financial literacy included a beautifully stated observation:

“This [financial literacy] is a topic that should be taught as early as possible in order to curtail the mindset of fast money earned on the streets and gambling being the only way to improve one’s financial circumstances in life.”

The statement touches on the relationship between risk and reward and on the notion of delayed gratification. It also suggests that kids can grasp the fundamentals of financial risk.

The need for financial literacy is clear. Many adults don’t grasp the concept of compound interest, let alone the ability to calculate it. We’re similarly weak on the basics of risk. Combine the two weaknesses and you get the kind of investors that made Charles Ponzi famous.

I browsed the web for material on financial risk education for kids and found very little, and often misguided. As I mentioned earlier, many advice-giving sites confuse risk taking with confidence building.

On one site I found this curious claim about the relationship between risk and reward:

What is risk versus return? In finance, risk versus return is the idea that the amount of potential return is proportional to the amount of risk taken in a financial investment.

In fact, history shows that reward correlates rather weakly with risk.  As the Chicago teacher quoted above notes, financial security – along with good health and other benefits – stem from knowing that some risks have much down side and little up. Or, more accurately, it means knowing that some risks have vastly higher expected costs than expected profits.

This holds where expected cost means the sum of the dollar value of each possible way to take the risk times its probability value, and where expected profit is the sum of each possible beneficial outcome times its probability. Here expected value would be the latter minus the former. This is simple economic risk analysis (expected value analysis). Many people get it intuitively. Others – some of whom are investment managers – pretend that some particular detail causes it not apply to the case at hand. Or they might deny the existence of certain high-cost outcomes.

I was once honored to give Susan Beacham a bit of input as she was developing her Money Savvy Kids® curriculum. Nearly twenty years later the program has helped over a million kids to develop money smarts. Analysts show the program to be effective in shaping financial attitudes and kids’ understanding of spending, saving and investing money.

Beacham’s results show that young kids, teens, and young adults can learn how money works, a topic that otherwise slips through gaps between subjects in standard schooling. Maybe we can do the same with financial risk and risk in general.

– – –

Postscript

A web site aimed at teaching kids about investment risk proposes an educational game where kids win candies by betting on the outcome of the roll of a six-sided die. Purportedly this game shows how return is proportional to risk taken. Before rolling the die the player states the number of guesses he/she will make on its outcome. The outcome is concealed until all guesses are made or a correct guess is made. Since the cost of any number of guesses is the same, I assume the authors’ stated proportionality between reward and risk to mean that five guesses is less risky than two, for example, and therefore will have a lower yield. The authors provides the first two columns of the table below, showing the candies won vs. number of guesses. I added the Expected Value column, calculated as the expected profit minus the expected (actual) cost.

I think the authors missed an opportunity to point out that, as constructed, the game makes  the five-guess option a money pump. They also constructed the game so that reward is not proportional to risk (using my guess of their understanding of risk). They also missed an opportunity to explore the psychological consequences of the one- and two-guess options. Both have the same expected value, but have much different winnings amounts. I’ve discussed risk-neutrality with ten-year-olds who seem to get the nuances better than some risk managers. It may be one of those natural proficiencies that are unlearned in school.

Overall, the game is constructed to teach that, while not proportional, reward does increase with risk, and, except for the timid who buy the five-guess option, high “risk” has no downside. This seems exactly the opposite of what I want kids to learn about risk.

No. of Guesses Candies Won  Expected Value 
5 1  5/6*1 – 1 = -0.17
4 2  4/6*2 – 1 = 0.33
3 5  3/6*5 – 1 = 1.5
2 10  2/6*10 – 1 = 2.33
1 20  1/6*20 – 1 = 2.33

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s