Tuesday, August 5, 2008

Why Financial Literacy Matters

In my previous blog, I posted three questions that can be used to measure financial literacy. In this posting, I want to discuss the answers to those questions and why getting them right matters.

The first question is:
Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

This question measures numeracy and knowledge of the power of interest compounding. The fact that interest grows on interest is an important concept to understand and explains how your investment can grow quickly over time.
There are two lessons to be learned from this concept:
1) To make the power of interest compounding work in your favor, it is important to start to save when you are young. Just a simple example: $1 invested at a 7% interest rate increases more than 7 fold in 30 years. This is pretty good, yes? (But see discussion of inflation below.)
2) It is important to borrow as little as possible with credit cards or through other high cost means. Borrowing at an interest rate of 20% means that it takes fewer than 5 years for your debt to double. To me, this seems to quickly hurt.

The second question is:
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?

This question measures knowledge of inflation. Inflation is simply the change in prices overtime. If prices increase, it means you can buy less with your money.
There are two lessons to be learned from this concept:
1) You need to protect against the erosion of your purchasing power. Because of inflation, the money you have today will buy less in the future, so you need to invest your money at an interest rate that is higher than the inflation rate. If inflation is at 3% and you earn 1% on your savings account, believe me, you are not doing well!
2) It is important to take inflation into account when planning for the future. In other words, do not expect the prices tomorrow to be the same as the prices today.

The third question is:
Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”

This question measures knowledge of risk diversification. This is a very important concept that relates to the old adage 'don’t put all of your eggs in one basket.' A simple fall and you have a "frittata," as we say in Italian.
Again, there are lessons to be learned from this concept:
1) Make sure that a single event does not put a big dent in your investment. For example, why invest in a single stock? Why give all of your money to your brother-in-law who wants to open a cigar shop? Firms can fail and people can stop smoking.
2) Investing in your company stock is very risky; if your company goes under, you will lose the money you invested when you need it most. Even if you like your company a lot, why take so much risk? Clearly, I am lucky; Dartmouth is not listed on the NASDAQ and I do not have to face this decision.

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