There are millions of things to know about finances and investing, literally thousands of pages of law, math and history.
Yet an amazing 70% of Americans can’t answer three questions about money asked by a couple of retirement teachers.
Here they are:
Suppose you have $100 in a savings account and the interest rate was two 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. I don’t know
Imagine that the interest rate on your savings account was one percent per year and inflation was two 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 as today
C. Less than today
D. I don’t know
Do you think the following statement is true or false: Buying a single company stock usually provides a safer return than a stock mutual fund.
The concepts being explored here are compound interest, inflation and diversification. Where many people get tripped up is understanding how money is affected, positively and negatively, by time.
For instance, in the first question, the important factor is five years of time. It’s easy to conclude that one year of interest on $100 is $2 extra in the account.
But what happens after five years? It should be obviously “More than $102,” since even if the interest is not reinvested, that’s still five years of $2 being added each year.
So we get $110. If you consider compounding, it’s actually $110.41. Far more than $102. Yet people miss this one.
The compounding effect is even more clear when you stretch out the time. Consider a $10,000 annual investment growing at 7%. Over 30 years it turns into $1,086,853.
You might easily think that $10,000 times 30 is just $300,000 and you’d be right — if you took out the annual interest earnings to spend. If you leave it in the investment that money grows too and becomes more than three times the savings.
The second question is another softball that people somehow miss. If you earn 1% but prices rise at a rate of 2%, that means your purchasing power is less over time.
Inflation is a big deal. That’s why investment advisors strongly advocate that their clients own stocks rather than bonds or other asset classes. They are more volatile, but stocks also tend to outpace inflation over long periods.
Finally, consider what the third question is really asking: Do you take your chances on one company or a fund that owns many companies?
If that one company turns out to be a winner and handily beats the whole stock market, you’d want the single company.
But it’s extremely difficult to choose a single investment that is a winner. In fact, it’s more likely that you will either choose a company that will underperform or even go bankrupt.
Diversification, owning many companies, means you spread the risk out over multiple individual investments which can lower your overall risk. You still get the growth from owning stocks.
Understanding these three basic ideas about money will put you ahead of 70% of Americans and well on your way to a solid financial future.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.