Suppose you had $100 in a savings account and the interest rate was 2 percent 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.
Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent 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.
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.
Answer to Question 1: More than $102.
Here’s why: On savings of $100 a year at 2 percent interest, your money earns $2 a year (100 x .02) for five years: a total of $110.41.
Why is the total more than $110? The reason is compound interest, interest earned added to the account balance so that the interest also earns interest. As your account balance grows, each new interest payment is based on a larger amount. Compounding speeds up earnings.
Use this compound interest calculator at Investor.gov to see how compound interest works.
Answer to Question 2: Less than today.
Here’s why: Your interest rate on savings is 1 percent a year, or $1 a year on every on $100.
Inflation (rising prices) reduces the value of money. At the rate of 2 percent, inflation reduces the value of your $100 savings by $2.
So, you earn $1 (for every $100) in interest, but lose $2 to inflation, for a net loss of $1, giving you effectively less than your savings are worth today.
Answer to Question 3: False
For most investors, mutual funds are a better investment than stocks because, as Money Talks News founder Stacy Johnson says, “You can do perfectly well with a mutual fund, while at the same time lowering your risk and reducing your hassle.”
A mutual fund is a huge pool of investments. Stacy explains in Ask Stacy: How Do I Invest in the Stock Market?:
It could be a pool of stocks — a stock fund. It could be a pool of bonds — a bond fund. Or it could have both stocks and bonds — a balanced fund.
Mutual funds are superior for most investors because:
- They spread the risk of stock investing by diversifying investments among many stocks with a variety of risk profiles.
- The work of managing, researching, buying and selling stocks is done by professional managers, not by you.
- Mutual funds do the record-keeping you’ll need for taxes for you.
Mitchell and Lusardi’s little quiz can serve as a wake-up call to alert you to the need to learn more about money basics. Concepts like risk, inflation and compounding go beyond basic arithmetic, and few of us were exposed to them in school. They matter because of two trends: the loss of private pensions and the explosion of financial products, both of which require everyday consumers to make sophisticated choices about complex loans, credit cards and investments.
Fortunately, these subjects aren’t difficult to understand, and there are excellent free resources for learning.
Financial Ignorance Cripples
Financial ignorance is a crippling handicap. It makes people buy high and sell low, make poor investments, mismanage budgets, overspend and become trapped in unmanageable debt.
If the growing wealth gap between rich and poor has you worried, consider this: Lusardi and her colleagues find that a third of wealth inequality is because of the financial-knowledge gap separating the well-to-do from those with less money. “[M]ore knowledgeable individuals invest in more sophisticated assets, suggesting that they can expect to earn higher returns on their retirement savings accounts,” the Wharton article says.
Money savvy consumers:
- Take on less credit card debt.
- Pay off balances each month.
- Refinance their mortgage at the best moment.
- Avoid high-cost debts like payday loans.
- Plan for retirement.
Get Educated, Free
Here are several sources for free personal-finance education:
- Money Talks News. Learn money savvy on subjects like Credit & Debt,Retirement, Taxes, Investing, Insurance and subscribe to daily newsletterswith articles like:
- Does Money Lingo Make Your Head Spin? Here’s What It Really Means.
- Ask Stacy: How Do I Invest in a Mutual Fund?
- How to Talk Money With Your Spouse.
- 8 Secrets to Building a Budget You Can Live With.
- The National Endowment for Financial Education’s Smart About Money. The nonprofit explains how to save, invest, pay off debt and borrow safely.