More and more Canadians will have to plan for their own retirement and public policy makers have provided some and are no doubt contemplating further mechanisms to help. The Tax Free Savings Account (TFSA) is the latest but unlikely to be the last. Unfortunately, all of these tools make retirement planning more difficult and seem to place an unrealistic burden on consumers to make sound financial decisions. Many of us are poorly prepared because we don’t understand risk.
To reach retirement goals people must invest a share of current resources with an understanding that the pool of resources will grow (at a rate higher than inflation) but doing so involves assessing risk… the probability of making or losing money with different investment options.
Risk is all about probability. Consumers in general, do not understand probability very well. A recent global study by TNS shows that with some variation across countries, there is considerable lack of understanding of financial risk among consumers. Canadians are about average.
When asked three financial risk questions (one on lottery payouts; one on investment risks and returns; and one on single versus a basket of stocks, only 13% correctly answered all three. The best performance was in understanding that a single stock is more risky than a basket of stocks (57% got this right).
We are certainly putting into practice our questionable understanding of financial risk. Consider the introduction of TFSAs in Canada last year. After one year, 94% of TFSA investments are in savings accounts or term investments according to BMO Financial (see story). This is the ultimate in conservative, low risk behaviour that reflects a fundamental disconnect between the financial vehicle (the TFSA) and the risk people are taking.
The real value of a TFSA is the fact that the income earned on the investment is not taxable so investing in a product that generates little interest is of little value to Canadians. The TFSA is the place to take a risk because the payoff is so much higher.
While some conservative investment may be a reaction to the fiscal crisis, the evidence is clear. We are collectively not taking appropriate risks. With more and more Canadians relying on their own investments to sustain their retirement, the failure to understand risk threatens to undermine the positive benefits of empowering people to take control of their own futures. In addition, financial advise (and marketing of financial products) need to be tied to a better understanding of how consumers process and evaluate risk.