The competition for people's limited time and learning capacity affects the teaching of economics in our schools. What do we eliminate to make room for economics and the related field of personal finance? Do we have to eliminate reading, social studies, music, health or sex education? There are trade-offs.And that leads me to another meaning to economic literacy that can be immensely powerful, and it deserves a great deal of attention. It's the kind of economic literacy that addresses the question of what kind of economic knowledge is most useful to people in their everyday lives as workers and voters. Economists are fond of saying that economics is all about trade-offs. You know the cliches: «You can't have it all». Or «there is no free lunch». The idea of trade-offs underlies such most basic economic ideas.
Indeed, economics is often called the «imperial» social science. The systematic study of trade-offs has swept other disciplines, from political science to sociology and law. The «science of choice» is so powerful and widespread that it has the potential to become the fifth major category of knowledge in the university, in addition to the current physical sciences, the natural sciences, human sciences, and social sciences, according to Charles Lindblom, professor emeritus at Yale University.
Teaching high-school students — or anyone else for that matter — about the fundamentals of thinking through choices logically would be extremely useful. Paul Romer, economist at Stanford University, views the fundamental task of teaching economics as helping students «set aside their immediate emotional reactions and to reason carefully about the question at hand». Again, it's that trade-off thing.
For example, whenever there is a tragic accident at a railroad crossing, some group will suggest that the imperative of saving lives demands getting rid of all the railroad crossings. Instead, cars should travel under a railroad bridge. Sounds reasonable.
But this kind of rerouting and rebuilding costs a lot of money, and you quickly get to the point where the money might be better used elsewhere. The same is true for other «tragic choices», from airplane accidents to environmental improvements.
A deeper understanding of trade-offs can contribute to a better economic life, especially in the area of personal finance. Take the widespread embrace of investing in stocks, bonds, and other financial assets. These days, it's almost impossible to get away from the markets. Like civic associations at the turn of the 20th century and homeownership following the Second World War, investing now has all the characteristics of a powerful mass social movement. Millions of people are flocking to Wall Street to save for their retirement, for their children's college education, and for a financial safety net against a corporate restructuring. Wall Street has become middle class and mass market.
Several decades ago, economist Harry Markowitz wrote an influential paper in the history of modern finance theory. Yet hardly anyone paid attention to his work on diversification and risk management. «Milton Friedman even doubted that Markowitz's work merited the PhD that Markowitz hoped to earn with his thesis on diversification», says Peter Bernstein, an investment advisor and leading market historian. «Risk management in those days meant buying bonds and holding them to maturity», he adds.
Today, the modern portfolio of ideas of asset allocation and diversification — all constructed from the fundamental trade-off between risk and return — is taught to investors by mutual fund companies, business magazines, personal finance sites on the Internet, and elsewhere in the personal finance universe.
Sure, we can all tell tales of appalling investor ignorance. But we are also moving up the learning curve.
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