It seems that politicians on both sides of the Atlantic aren’t the only ones in denial about their countries’ finances. Some U.S. consumers either don’t know important financial concepts or choose to believe only what they want to believe.
A new study by the Federal Reserve Bank of New York compared what people said they owed on their credit cards with their actual balances. Overall, consumers admitted to only about 50 percent of their indebtedness, although that number rose to between 52 percent and 66 percent when allowances were made for factors like the “convenience” use of such cards — i.e., using plastic rather than cash, then paying off the balance each month.
Meanwhile, a 2010 survey by professors Annamaria Lusardi of Dartmouth College and Peter Tufano of the University of Oxford found shocking levels of debt illiteracy: Only about one-third of American consumers understood compound interest or how credit cards worked, at considerable cost to themselves.
Lack of financial or mathematical acumen also plays a role in another potentially expensive miscue, this one made by bearish investors hoping to capitalize on the chronically turbulent global economic environment. In recent years, exchange-traded funds that move inversely to an index have become popular. As if playing the downside isn’t risky enough, however, some inverse ETFs offer double or triple leverage. If the Standard & Poor’s 500 benchmark declined 2 percent, for example, a double-inverse ETF based on the index might be expected to gain 4 percent.
Which is usually close to what happens, but only on a single day. Over more extended periods, the mathematics of investing can distort the results beyond all recognition. The Securities and Exchange Commission has heard horror stories of investors thinking they struck gold in a leveraged inverse ETF during a steep market selloff, only to learn they were among the losers themselves. On its website, the SEC explains how and why returns from such leveraged funds aren’t what you would necessarily expect over weeks, months or years. Check the online SEC “alert” before plunking a single dime into a leveraged inverse ETF.
If you can’t find sound businesses in which to invest long-term money, it’s better to hold your powder until you can. Cash may pay next to nothing at the moment, but next to nothing still beats an erroneous bet on economic disaster or ruining your portfolio by using leverage, especially on the downside. Remember, it was the mistaken use of leverage — and credit — that caused the global financial crisis in the first place.
Borrow wisely, invest prudently and wait patiently.