Well, here we are in April which is officially Financial Literacy Month in the US so it seems a great opportunity to discuss the very important topic of financial literacy.
Many western democracies are facing a private debt crisis and this is a problem which can’t be blamed solely on the pandemic – it has been brewing for years (although the pandemic has certainly done nothing to help). A big part of the problem is a lack of financial literacy, which isn’t hard to explain, given that few of us receive any kind of formal training in even the most basic of financial concepts.
Two thirds of adults worldwide are financially illiterate
The Global Financial Literacy Excellence Center (GFLEC) works hard to improve financial literacy and bases its measurement of financial literacy on four basic financial concepts: risk diversification, inflation, numeracy, and interest compounding. A presentation given by the GFLEC’s Professor Annamaria Lusardi in November 2020 on The importance of financial literacy: Evidence and recommendations is damning, coming to the general conclusion that ‘the level of financial and risk literacy is very low’ with only 1 in 3 adults worldwide possessing basic financial literacy. Are you one of them? Does it matter?
Does it matter if I’m financially literate?
The GFLEC states that ‘On average, people with a good grasp of financial and risk concepts are twice as likely as those without to make better financial decisions’ so yes, if you want to go through life making sound financial decisions that will protect you and your family, build your wealth and bag you a comfortable retirement, financial literacy is important.
Financial literacy is also described as a shield against shocks so when unexpected events come along – whether that be a pandemic which obliterates your source of income or an illness which means that you need to take time out from working – you won’t have to compromise on standard of living.
Are you financially literate?
Test your financial literacy by answering these four teasers on some of the basic financial concepts that everyone should understand.
1. How compounding affects savings
Question: If you saved one cent and it doubled in value every day over the course of a month, how much money would you have at the end of the month?
a) $10,000 b) $100,000 c) over $10million
Described by Albert Einstein as the ‘eighth wonder of the world’ compounding is perhaps the single most effective tool a saver or investor has in their toolkit but it is frequently under-appreciated! Compounding is basically the interest paid on interest. This question is a much-used example which powerfully demonstrates just how effective compounding can be. The astounding answer is $10.7million! If you don’t believe it, here’s how it works:
Of course, in reality no investment earns 100% interest every day, but the compounding effect is what turns modest monthly savings over a long period into sizeable nest eggs for canny savers the world over to retire on.
2. How compounding affects debt
Question: If you splashed out on a $500 designer bag using a credit card which charged 18% interest per annum but you only made minimum payments of 2.5% each month, how long would it take to pay off the debt?
a) 1-2 years b) 5 years c) more than 10 years
The answer is more that 10 years, which for me, as a financial adviser, is obvious but clearly isn’t to the many people who regularly use credit cards. To my mind, buying things on a credit card with 18% p.a. interest is lunacy. In fact, I question the need to have a credit card at all.
March 2021 stats from The Money Charity in the UK calculate average credit card debt in the UK at £1,057 per adult. The charity estimates that ‘a credit card on the average interest would take 24 years and 7 months to repay, making only the required minimum repayments each month.’ Think twice before flexing that plastic.
Question: You have $1000 in the bank which earns 1% interest per year. Inflation is 2% per year. After one year, will your savings be able to buy:
a) more than today b) the same as today c) less than today
If the rate of inflation is higher than the rate of interest you are earning on savings, your buying power/wealth is diminishing so the answer is less than today. This is why it is risky to keep all your savings in the bank where interest rates are currently so low that they are not even keeping pace with inflation, even though it is also on the low side for now.
4. Investment returns
Question: Which asset class has produced the best returns over the past 10-20 years?
a) the stock market b) bonds c) property
According to Investopedia ‘The U.S. stock market has long been considered the source of the greatest historical returns for investors, outperforming all other types of financial securities and the housing market over the past century or so.’ Nevertheless, the general perception of the stock market is that it is risky, a fact which puts many potential investors off.
That is not surprising given that the GFLEC notes that ‘Risk-related concepts are the most difficult to grasp and the least understood.’ however, financial investment puts your cash to work immediately. I’d argue that if you invest mindfully this is lower risk than putting money in the bank where it will earn next to nothing. No investments are risk-free but the risk can be mitigated by diversifying. A financial adviser can help you with choosing investments which will build your wealth while keeping risk to a level you are comfortable with.
So does our short quiz leave you feeling financially literate or do you think you have a lot to learn? If you are lacking the basic knowledge to make sound personal finance decisions you’ll find a wealth of resources on the GFLEC website to improve your literacy.
There’s no need to let a lack of knowledge prevent you from starting to build wealth for a secure future. However financially literate you are, a financial planner can help you work out the best ways to save and invest. If you’re looking for a financial adviser in China, give me a shout at firstname.lastname@example.org and together we can get your finances in great shape for a positive future.
I work as a Financial Planner with expat clients to meet their financial planning needs and goals, with a focus on adequately protecting expats & their families, and helping people to grow their savings over the long term. I strongly believe in building meaningful and lasting relationships with clients to ensure the best client outcomes are achieved.