BLOG: Are you financially literate?
There is a financial literacy test doing the rounds. The test – created by Standard & Poor’s, Gallup, the World Bank, and George Washington University – asks five questions (listed below) and is designed to test whether you understand basic concepts such as compound interest, inflation and diversification.
Only around a third of the global population get the answers right, which may explain a few things about the way people manage their finances – their reliance on credit, for example, or their reluctance to invest in the stock market. While the quiz sounds simple (and shouldn’t tax any discerning YourMoney.com readers) we believe it highlights a few key points that everyone should know:
1) Compound interest
This is your best financial friend. If you invest £100 in your first year, and get 5% growth, the next year you don’t get £100+5%, you get £105+5% (£110.25). It really is money for nothing and it is the best way to grow your money.
2) Compound interest II
This works the other way. If you are paying 15% on your debt, it is not just your original debt that is increasing by 15% every year, it is the debt on your debt. In the first year you owe £100+15% = £115. In the second year, you owe £115+15% = £132.50. That mounts up very quickly.
If your money doesn’t grow, you will find yourself with less spending power because of inflation. You may think that it’s safe to leave your money in a bank account paying 0.5%, but with inflation at 2.9%, that equates to a significant loss in real terms over time.
It is so tempting to look for that technology stock, the new Amazon, that’s going to make you £1m. So you put everything on red. The trouble is, Amazon already exists, and you’ve probably just backed a loser. It is vitally important to hold a spread of investments, so that if one stock is losing, another stock may be winning. People tend to be particularly guilty of this with their company stock.
5) Fixed is often better than annual
£5 today is better than 3% recurring year after year.
Suppose you have some money. Is it safer to put your money into one business or investment, or to put your money into multiple businesses or investments?
- a) one business or investment
- b) multiple businesses or investments
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 than you can buy today, the same as you can buy today, or more than you can buy today?
- a) less
- b) the same
- c) more
Suppose you need to borrow 100 US dollars. Which is the lower amount to pay back: 105 US dollars or 100 US dollars plus 3%?
- 105 US dollars
- 100 US dollars plus 3%
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 than it did the first year, or will it add the same amount of money both years?
- a) more
- b) the same
Compound interest II
Suppose you had 100 US dollars in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account?
- a) more than 150 dollars
- b) exactly 150 dollars
- c) less than 150 dollars
Of course, you know the answers, but just in case – b), b), b), a), a).