Financial literacy is a must for every adult, yet few high schools, if any, teach it. And as a recent Standard & Poor's survey demonstrated, many people aren't getting the knowledge they need elsewhere. The survey found that only 57% of American adults could correctly answer three out of four basic financial questions and get a passing score. Take a look at some of the questions they were asked and see if you would have made the grade.
Survey question: Is it safer to put your money into one business or investment, or to put your money into multiple businesses or investments?
The answer should be obvious. Diversification means that owning several different types of investments will reduce your risks compared to owning just one type of investment. For example, if the S&P 500 Index drops by 30% and you have all your money in an S&P 500-tracking index fund, then your portfolio will lose 30% of its value. But if just half your money is in stocks and the rest is in other types of investments, your portfolio will lose only 15% of its total value instead.
It is usually a good idea not only to spread your money across different asset classes, but also to diversify within asset classes. For example, don't put all your stock money into a single stock. Instead, invest in a broad array of stocks and a broad array of sectors (e.g. tech, healthcare, finance, consumer staples, etc.). That way, if one stock goes bust or one industry hits the skids, you won't lose all the money you’ve invested.
Survey question: Suppose over the next 10 years the prices of the things you buy double. If your income also doubles, will you be able to buy less, the same, or more than you can buy today?
The answer is the same. Inflation is the increase in prices and the decrease in the value of your money over time. In 1968 you could buy a Big Mac for about $0.49; by 2015, the price of a Big Mac in most places was $4.79. That's inflation in action.
On the other hand, the median household income in 1968 was $8,630, and by 2015 it was $56,516. That means a Big Mac is nearly as affordable as it was 50 years ago. Ideally, prices and incomes rise at the same rate so that consumers don't lose purchasing power.
Assuming prices and income do rise in tandem, as in the question above, you'll be able to afford the same things in the future that you can buy today. For example, if your basic monthly expenses double (say, from $3,000 to $6,000) and your monthly income also doubles (say, from $4,000 to $8,000), you'll be spending the exact same percentage of your income on monthly expenses -- in this case, 75%. So even though prices have gone up, your paycheck still buys the same amount of stuff that it did before.
Survey question: Suppose you put money in the bank for two years and the bank agrees to add 15% per year to your account. Will the bank add more money to your account the second year, or will it add the same amount of money both years?
The answer is more. Compound interest is the reason financial experts all tell you to start saving for retirement early. The interest you earn on your investments is added to your account balance, so in the future, you'll earn interest on that interest. As your balance grows, so will the interest you earn; this creates a virtuous cycle whereby your wealth grows exponentially.
Let's break that down with a hypothetical, specific example based on the survey question above.
For illustrative purposes, we will use an interest rate that is much higher than the historical average. Say you put $1,000 into a bank account that pays 15% interest annually. the end of the year the bank would add 15% of $1,000 to your bank account, which comes to $150. That means your bank balance is now $1,150.
If you leave all of that money in your bank account, then at the end of the following year, the bank would now add 15% of $1,150 to your account, which is $172.50. Even though you didn't add any more money to the account and the interest rate didn't change, the bank is paying you $22.50 more than it paid last year. That's the beauty of compound interest.
The effects of compound interest are truly enormous over long periods of time. In the above hypothetical example of a bank account paying 15% interest, if you deposited $1,000 in the account and left it alone for 10 years, you'd have $4,046. After 20 years, you'd have $16,367. And after 30 years, you'd have $66,212. That's right: You'd have 66 times as much money in the account as you started with, without ever adding another penny of your own money.
The financial concepts that these three questions explore -- diversification, inflation, and compound interest -- are incredibly important for every adult to understand. They're especially important concepts for investors, as they help you to decide how to potentially earn the best possible return on your investment. So if you're still unclear on any of these concepts, now's a good time to start brushing up. A few minutes today spent understanding basic financial concepts and how they apply to you could pay off big time over the long run.