In a previous blog, I shared a three-question financial literacy assessment that is used widely in the United States and in many other countries as well. It was developed over 20 years ago by two college professors, Lusardi and Mitchell. The questions cover the concepts of compound interest, inflation, and risk diversification. I promised a follow up blog to review the questions and explain the correct answers.
Compound Interest
1. Suppose you had $100 in a savings account, and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?
a. More than $102
b. Exactly $102
c. Less than $102
d. Do not know; refuse to answer
The correct answer is ‘a.’ – more than $102.
Compound interest is the interest you earn over time on both your original investment plus any reinvested interest. In the example above, the original investment is $100. That is also called the principal. The interest rate is 2% or 0.02. In the above example, interest is paid once at the end of the year = $100 X 2% = $2 interest. If you left the principal intact and added the $2 interest, you would start the second year with $102. At the end of the second year, you would have earned $102 X 2% = $2.04 interest. Add the $2.04 newly earned interest to $102 and you start the third year with $104.04.
Year 3: $104.04 X 2% = $2.08 interest. Add $104.04 + $2.08 interest = $106.12
Year 4: $106.12 X 2% = $2.12 interest. Add $106.12 + $2.12 interest = $108.24
Year 5: $108.24 X 2% = $2.17 interest. At the end of the fifth year the original $100 has grown to $110.41!
The frequency of interest payments can vary – daily, monthly, quarterly, annually. Our example used an annual interest payment. Compound interest is a powerful tool for building wealth over time.
Inflation
Inflation is defined as a broad increase in the prices of goods and services, which leads to a decrease in the purchasing power of money. Over time, you need to spend more money to purchase the same goods and services. Let me share a personal example.
My oldest sister was in college when I was born. She was married when I was two years old. My parents contributed $200 toward the expenses of her wedding. I was married 19 years later. My parents, who were very fair-minded people, contributed $200 toward my wedding. They made no adjustment for inflation although, as you can imagine, wedding expenses increased dramatically over those years. The purchasing power of $200 decreased. (I made it work and had a lovely wedding!)
The second question of the financial literacy assessment is as follows:
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?
a. More than today
b. Exactly the same
c. Less than today
d. Do not know; refuse to answer
The correct answer is ‘c.’ – less than today.
Any time your investment earns less than the rate of inflation, you are losing ground.
Risk Diversification
3. Please tell me whether this statement is true or false: “Buying a single company’s stock usually provides a safer return than a stock mutual fund.”
a. True
b. False
c. Do not know; refuse to answer
The correct answer is ‘b.’ – False.
I am sure you know the adage, “don’t put all your eggs in one basket.” The point is that diversification is good and that goes for your investments as well. Diversification means that you choose a wide range of stocks or bonds, instead of just one or two or a handful, and that reduces risk. The Motley Fool suggests that you should own 20-30 different stocks to be adequately diversified. Other sources suggest as many as 50!
Illustration by Example
When I was an investment advisor, I had a client who was employed by a large industrial company. Let’s call my client Stan and the company he worked for ABC. Stan was very proud of ABC and spent most of his working life in its employment. ABC offered employees the opportunity to buy company stock at a discount. That is a good deal, and Stan took advantage of it. ABC’s retirement plan account also allowed him to purchase ABC stock and Stan did. He also opened a brokerage account through which he purchased even more ABC stock. ABC company did well for a long time and Stan was thrilled.
When Stan came to my office and I talked to him about diversification, he was not interested. Stan knew ABC in and out and was confident in its future. The last time I saw Stan was just before ABC took a huge hit in the market because demand for their major product plummeted. I tried to get in touch with Stan, but he would not return my calls. I am sure that Stan survived because ABC company switched its product line and is doing quite well, but I know that Stan’s plans for retirement must have changed or at least been delayed.
If Stan had kept some of his ABC stock but diversified the rest of his accounts, he would have suffered but not to the same extent. Picking a single, or even a couple of stock winners is very difficult to do consistently over time – even for the pros! The added diversity of owning many companies and types of companies reduces risk.
If you have a question about the above concepts, please contact me through my website, www.bevbowers.com. I am no longer registered to give personal portfolio advice, but I am happy to answer any generic questions. My book, How to Dress a Naked Portfolio: A Tailored Introduction to Investing for Women, covers these topics as well. It is available in paperback or eBook format on Amazon.
Questions:
What are two ways to diversify an investment portfolio? (Spoiler alert – watch for my blogs on mutual funds and exchange-traded funds.) What financial topics would you like addressed in my blogs?
