Are you Financially Literate? The Answers...
Following our article (and your comments) on financial literacy “Are you Financially Literate? Take this Simple 3-Question Test to Find Out”, we decided to take a look at the correct answers in more detail.
Created by Annamaria Lusardi and Professor Olivia S. Mitchell, this financial literacy test has now been used in more than 20 countries to measure financial knowledge. The “Big Three”, as these key questions have come to be known, can reveal a lot more about your understanding of finances than you may realise. Remember the questions?
1. Suppose you had £100 in a savings account and the interest rate was 2% per year. After 5 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
- e) Refuse to answer
The answer is a). This question measures numeracy and reflects what is called compounding interest (see Vestpod): the notion of making money on money.
When you put £100 in a saving account that pays 2% interest rate per annum, it means you will earn £2 interest (2% x £100 = £2) over the year and end up with £102 in your saving account after one year.
In year 2, you will earn your interest on the balance of the account (£102), so that’s £102 * 2% = £2.04. You end up with £102 + £2.04 = £104.04.
Same idea for years 3, 4 and 5…
After 5 years, you will end up with a balance of £110.41, much higher than your £100 initial investment. Got it? Ok, so now let’s move on to the next question where we will be adding inflation into the mix.
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 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
- e) Refuse to answer
The correct answer is c). This question helps explain inflation (as we did in our Vestpod article here). Say you have £100 in your account, and you are earning 1% interest on it. You will end up at the end of the year with a balance of £101. However, inflation of 2% means that the prices of goods in the shops are going up by 2%.
That pair of shoes was priced at £100 at the beginning of the year and you could afford it. You invested your £100 at a rate of 1% and have £101 in hand. All good. But with inflation, a year later, those shoes cost £102. You are short £1 and cannot afford them anymore! Grr. This is why we always stress the importance of investing in a low interest rate, high inflation savings environment.
That second question measured understanding of inflation in the context of a simple financial decision. The third and final question gauges your knowledge of risk diversification. It’s really a joint test of knowledge about ‘stocks’ and ‘stock mutual funds’ and of risk diversification, and the correct answer depends on knowing what a stock is and that a mutual fund is composed of many stocks. Since employees are increasingly asked to select their pension investment portfolios, it is important to pin down our understanding of risk diversification.
3. Is this statement 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
- d) Refuse to answer
The answer we’re looking for here is b). This question helps you understand the benefit of diversification. We all know the phrase “Don’t put all your eggs in one basket”. Stocks go up and down. This is why building a diversified portfolio ensures that at least some of your investment should be performing well. We don’t say it absolutely guarantees a profit or avoids making losses, but it certainly helps reduce risk and enhance returns.
Don’t hesitate to leave your comments below!
Photo by Sebas Ribas on Unsplash.