Can you ace the FINRA financial literacy quiz?
In 2009, the Financial Industry Regulatory Authority (FINRA) developed a six question quiz to measure the financial literacy of Americans. The most recent 2018 results were pretty dismal: only 40% of Americans were able to correctly answer at least four of the questions. How would you score?
The quiz was designed to highlight key concepts that are fundamental to how you manage your money today, and how to plan for the future:
- The power of compounding interest (both good and bad)
- The effect of inflation on your financial goals
- The importance of diversification in investing
- How bond prices work
I am not going to give you the quiz answers here. (Sorry!) But I will let you in on why these concepts are so vital and how they apply to the decisions that you make each day.
Albert Einstein famously said that compound interest was the 8th wonder of the world. When you are saving for a long term goal such as retirement, the power of compounding — the fact that you earn interest on interest — is extremely powerful. Investing $100 a month today will yield $54,914 in 20 years; if you wait just five years before you start to invest that same amount, your result will only be $32,583. What’s the lesson? You cannot wait to save for retirement until things are “better.” Small amounts invested early can yield far more than even a larger amount later on.
Have you heard of the Rule of 72? Divide the number 72 by the rate of return you expect your investment will earn. That is the number of years it will take for your money to double. If your retirement savings can earn 8% annually, your balance today will double in nine years even if you never invest another dime.
Alas, compounding interest cuts both ways. You may have seen this most poignantly if you are repaying your student loans under an income-driven repayment program that sets your monthly payment so low that it does not cover the accruing interest charges. This is called negative amortization. As an investor, you are paid interest on the interest you earn; as a borrower, you pay interest on the interest you are charged. This is why your loan balance may grow, even as you make regular monthly payments. The only solution is to make payments that are large enough to at least cover the accruing interest each month.
Inflation is a pretty well known phenomena. As a saver, the concept to master is that if the rate of return on your investments is less than the rate of inflation, you are running backwards. As well, when you project what you believe you will need in retirement for a comfortable lifestyle, you cannot think in terms of what your ideal lifestyle costs today.
What will your standard of living require 10, 20 or 30 years from now?
Diversification (aka “Don’t put all of your eggs in one basket”) is one of the most fundamental principles of investing, or perhaps even of life! You may appreciate intuitively that if you invest everything you have in the stock of just one company, you are taking a bigger risk than someone who spreads their wealth around a variety of investments. But are you as diversified as you think? If you own a great deal of your own company’s stock, you are doubly exposed to the fortunes of the company, as both a stockholder and an employee. If you own index mutual fund XYZ that invests in the S&P 500 and index mutual fund ABC that follows the Russell 1000 Index, well, you have two different investments that are actually not at all very diverse from each other. Both funds would hold a pretty similar portfolio of mostly large US companies, and their value will rise and fall close together.
Finally, the mystery of how bond investments work is enduring. Here is the most basic point: when interest rates in the economy go up, the bond that you already own is worth less. Why? Because no one wants your bond paying 2% interest if they can buy a new one in the market that pays 3%. When interest rates go up, the price of your bond (the amount that you can sell it for) goes down. And vice versa, of course. How can you use this knowledge? Consider that the longer the term of the bond until it matures and you are finally paid the principal, the more likely interest rates will change during this period of time while you own it. For that reason, a “long” bond that does not mature for 20 or 30 years is riskier than a “short” bond that reaches maturity after just a few years, or even less. A lot can happen over all of those years and the price of the bond will go up and down to reflect that.