"[T]hose with more advanced financial knowledge are those more likely to be retirement-ready." So say researchers Annamaria Lusardi and Olivia S. Mitchell in a 2010 study of financial literacy. When it comes to your financial security, what you don't know can really hurt you.
Let's look at some of the questions these researchers asked in a survey of Americans, and review what can go wrong when you don't understand various concepts.
Can you answer this one? "Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?" About 87% of respondents understood that you lose ground when inflation exceeds your return -- but that means 13% did not.
People who don't know that inflation has averaged about 3% annually over many decades will be ill-equipped to beat it. Even if they earn 8%, on average, they won't realize that their "real" inflation-adjusted return may be closer to 5%.
Savvy investors aim to beat inflation handily. That's why some invest in Freeport McMoRan Copper & Gold (NYSE: FCX ) and other commodity stocks. In addition, companies that sell staples and have pricing power can also keep up with inflation, as can their shareholders. Tobacco kingpin Altria (NYSE: MO ) can often pass on any increases in tobacco prices to its customers.
The highest return
Then there's this question: "Considering a long time period (for example 10 or 20 years), which asset normally gives the highest return?" Among respondents, 38% didn't know that stocks outperformed bonds and savings accounts. Woe to those who count on savings accounts or bonds alone to build a portfolio to retire on.
Another: "If the interest rate falls, what should happen to bond prices?" Fully 68% didn't know that falling rates lead to higher bond prices. Many people choose to invest in bonds, but it's dangerous to do so without understanding how they work.
You can also profit in stocks that benefit from interest-rate movements. Brokerages such as E*TRADE (Nasdaq: ETFC ) and Schwab (NYSE: SCHW ) make much of their money from interest on the cash they hold for investors and the margin loans they make to them. Those profits have been squeezed tight in recent years, but should swell as rates rise.
"True or false: Buying a company stock usually provides a safer return than a stock mutual fund." Alas, 28% of the respondents got this wrong, favoring the individual stock over the fund. It's true that many mutual funds don't do as well a simple index fund. But while an individual stock carries the risk of falling to zero, mutual funds offer greater diversification.
People who trust a single stock can get burned, especially in company retirement accounts. That's what happened to many employees of BP when the Gulf spill occurred. Things are looking up for the company following a favorable recent government report, but many shareholders are still underwater.
The more you know, the savvier investments you'll likely make, and the more comfy your retirement will be.
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