Everyday financial decisions are becoming more complicated. Whether it's understanding superannuation and lifecycle saving, the concepts behind sophisticated financial products, or the growing number of insurance and investment options, there's strong evidence that many lack the ability to make wise money management choices. 

Policy-makers across the world are grappling to find ways to improve financial literacy – and newly released results of an OECD/International Network on Financial Education survey of almost 52,000 people across 30 countries suggest their jobs will not be getting easier in a hurry. 

An initiative born of the High-level Principles on National Strategies for Financial Education endorsed by G20 leaders in 2012, the survey's results reveal outstanding room for improvement. 

Little more than 40% of people understand the basics of compounding interest, the survey showed, while only 44% shop around when considering a financial product, and around one-half tend towards short-termism. Lack of understanding over diversifying investments also poses a concern, reported the OECD. 

Among the many pressing issues is finding accurate ways to measure financial literacy. In the fast-moving 21st-century world that demands instant answers, methods of evaluation are often distilled into three basic questions. 

"The big three questions", which are asked in various ways, are: Do you understand compound interest? Do you understand inflation? Do you understand diversification? – that is, should you invest in one blue-chip stock or in a variety of stocks?, says Hazel Bateman, a professor and head of the school of risk and actuarial at UNSW Business School. 

If people can answer those three questions "there are broad assumptions they are able to make better financial decisions, and are more likely to be saving for retirement and participating in the stock market", Bateman says. 

Matching the circumstances

Many factors influence a financial decision, such as numeracy skill, financial concepts and product features, along with personality traits and personal preferences or attitudes. 

So it's not surprising experts have been questioning the questions used to evaluate financial literacy and the behavioural conclusions drawn from their answers. Some actually question the veracity of using formal questions at all. 

Ben Marshan, head of policy at the Financial Planning Association of Australia, says the association does not prescribe a method for its members to engage with clients on financial literacy.

We set out to find a small enough set of questions that would be useful when lengthy consumer surveying is not possible - Hazel Bateman.

"One of our professional standard rules is that they ensure their clients develop a deep understanding of the strategies and products recommended," he says. 

While every planner does it their own way, Marshan prefers deep conversations to straight-out questions to discover if a client understands a product or strategy because "everyone has different financial positions, goals and objectives, and different stages of life, levels of financial knowledge and approaches to risk", he says. 

Similarly, Lena Rizk, retail policy manager at the Australian Bankers Association, which has been running a financial literacy program since 2004, also highlights there's no one-size-fits-all solution for measuring financial literacy. 

However, the means of measurement must suit the circumstances, and the OECD/INFE opted for a sequence of open response, multiple choice and true/false questions for its recent international survey. 

Identifying gaps

On a quest to identify the most accurate questions, Financial Literacy Australia (FLA) awarded a research grant to Bateman and a team of researchers, including Susan Thorp, a professor at University of Sydney, Jordan Louviere, a professor at University of South Australia, and Christine Eckert, from University of Technology, Sydney. 

FLA wanted to find a comprehensive set of discriminating financial literacy questions – and a reliable method of measuring individual's capability to make specific financial decisions. 

"We set out to find a small enough set of questions that would be useful when lengthy consumer surveying is not possible," explains Bateman. 

The team selected three standard financial decisions – taking out a loan, buying life insurance and investing in the share market – and made some surprising findings. 

At the outset, when the team collected a multitude of questions from financial industry, academic and public agency publications, it aimed to identify at least one question for each category of numeracy skill, financial concept, specific financial product feature, and personality trait preference or attitude, but instead found some fields were lacking. 

Many financial literacy surveys in use only test objective knowledge and omit the personality bent of individuals and demographics, the team discovered. On top of this, they found no standard questions on insurance purchases or on common topics such as the taxation of investments. 

"Financial literacy in the insurance context is particularly under-researched. Where there were no relevant questions in our collected sources, we wrote new questions to fill the gaps," explains Bateman. 

Informative questions

After categorising their collected questions, the team selected 31 and then invited 84 financial literacy experts to assess how informative each of the questions were for identifying financial literacy for each of the three chosen financial decisions. 

They ended up with a list of seven questions each for loans, insurance and investment decisions – "the best of the current universe of questions" – that would reveal an individual's decision-making capability for each of the three fields.

The scoring system we had developed effectively measured an individual’s ability to make specific decisions, not just their understanding of financial concepts in general - Hazel Bateman.

The question sets selected by the financial literacy experts gave a high ranking to self-reported attitudes and personal traits as well as objective knowledge. They also differed considerably for the three financial decisions, and styles of questions varied for each category, indicating that a set of "one-size-fits-all" questions for testing financial literacy is unlikely to be adequate. 

The final top seven "most discriminating" questions for investment decisions to emerge from the new research all tested knowledge on risk, return, diversification and taxes. 

"For investment decisions, the financial literacy experts ranked objective questions higher, but this doesn't mean that psychological traits and attitudes are not important for testing the capability of making investment decisions," argues Bateman. She suggests the experts may have been more familiar with objective questions in this area. 

By contrast, in the case of loans and insurance, the experts selected attitudinal questions on budgeting (Can I afford this purchase?) and suitability (Is this financial product right for my needs?). 

All up, the seven most informative questions for loan decisions included some on psychological traits and attitudes (three out of seven), while the questions for insurance decisions were dominated by questions on personal bent (five out of seven). 

Scoring system

The researchers then asked a separate group of financial literacy experts to evaluate financial competency from any combination of correct or incorrect answers and, from this, developed a scoring model for their three sets of questions. 

Finally, the experts' capability scores were tested for accuracy by using responses to a survey of 1000 Australians who were asked questions on loans, insurance and investments with unambiguously "right or wrong" answers. 

"The scoring system we had developed effectively measured an individual's ability to make specific decisions, not just their understanding of financial concepts in general," Bateman says. 

The test questions showed consumers financial decision-making capabilities differ markedly between categories. For loans and investments, a very high number of respondents (89.9% and 87.3%, respectively) gave correct answers to the test questions, while only 39.3% of respondents answered the insurance question correctly. 

Further research is clearly required on financial literacy and insurance decisions, states Bateman. In terms of finding the right questions, this project is just the beginning, she emphasises. 

Bateman believes there's wide scope to extend the method across other categories of financial decisions, including superannuation. It also has applications for the improvement of financial literacy surveys, for financial institutions to test capability when selling products, and to better focus financial education initiatives, she says. 

To date, the project has delivered a bank of resources – including an inventory of questions and seven prioritised questions for loans, insurance and investment, and simple scoring methods for consumer capability scales – for use by the financial community through FLA.

Hazel Bateman is Head of the School of Actuarial Studies, Australian School of Business, UNSW. The article was originally published on UNSW's Business Think.