Grab a sheet of paper, and jot down your answers to the following financial questions:
1. Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, would you have more than $102, exactly $102 or less than $102?
a. More than $102
b. Exactly $102
c. Less than $102
d. Don’t know
2. Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?
a. More than it does today
b. Exactly the same
c. Less than today
d. Don’t know
3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
c. Stay the same
d. No relationship
e. Don’t know
4. True or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.
c. Don’t know
5. True or false: Buying a single company's stock usually provides a safer return than a stock mutual fund.
c. Don’t know
The answer key can be found at the bottom of this post. Grade your answers, and write down how many you answered correctly, how many you answered incorrectly, and how many you didn’t know.
This quiz was given to over 30,000 Americans and the results were, in my opinion, less than ideal. On a national level, respondents averaged 3 correct answers, 1 incorrect, and didn’t know the answer to 1. The results for the State of Wisconsin were almost the same as the national average.
What this survey tells us is that many Americans do not have a basic level of financial knowledge. I would contend that these questions represent basic financial knowledge that everyone needs to have in order to function in todays’ economy.
Question 1: This question is testing your knowledge of interest. When you keep money in a savings account, it will earn interest (admittedly less today than a few years ago). Each year, interest compounds, meaning that your interest then earns interest. Albert Einstein called compounding interest the 8th wonder of the world. This is why the earlier you start saving, the better.
Question 2: This question tests your understanding of inflation. Inflation refers to how much more things will cost you this year than they did last year. Each year that there is inflation (which is almost every year) your dollar will buy less than it did the year before. Even if your money grows by earning interest, if the inflation rate is higher than your interest rate, you will have less purchasing power, and therefore will be able to buy less than you could the year before.
Question 3: This may be the only one that you have a tough time finding applicable. Knowing how bond prices are directly affected by interest rates is necessary to understand and invest in the bond market. When interest rates go up, bond prices will fall. This is because bonds earn interest each year based on their locked in interest rate. Let’s say I have a $1,000 bond paying 6% interest and you want to buy it. Because interest rates have gone up, you can get a bond from another guy with 8% interest. Are you really going to pay me $1,000 for the bond? Probably not... you will pay much less than $1,000 to make up for the lower interest rate, meaning the value of my bond has gone down.
Question 4: This question goes at the heart of the 15-year vs. 30-year mortgage debate. This question frequently comes up with clients. Although payments will be higher with the 15-year mortgage, you will pay significantly less interest over the life of the loan because you are making 180 less monthly mortgage payments.
Question 5: The final question tests your understanding of the value of diversification. Owning a single company's stock is much more risky than owning a mutual fund that holds hundreds, if not thousands of company’s stock. If you only own one stock, as that company goes, so goes your portfolio. If you have all of your money in Coca-Cola, and the US suddenly bans Coke, then your investment will tank. If you own a mutual fund owning 1,000 companies, only one of which is Coke, then your portfolio will not be affected nearly as much. This makes owning a mutual fund much less risky than owning one stock.
I did some research on financial literacy while in Graduate School. What I can tell you is we don’t have a good understanding of how to help teach basic financial skills and education. The only thing I know to do is to continue sharing educational content, such as with this blog, and you can share your newly found (or already known) knowledge with as many people as possible (especially the younger generation).
So what do you think? How did your score compare to the national average? Do you think the results from this quiz are a bad thing, or does it even matter? Be sure to share your thoughts in the comments section!
1 - a. More than $102
2 - c. Less than today
3 - b. Fall
4 - a. True
5 - b. False
Alan Moore is a fee-only financial planner and founder of Serenity Financial Consulting in Shorewood WI. Follow him on Twitter @R_Alan_Moore. You can contact him at firstname.lastname@example.org, 414-455-5313, or visit his website at www.SerenityFC.com