This Could Kill Your Financial Future

"[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.

Inflation, shminflation
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.

Safe stocks?
"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.

Knowledge enriches
The more you know, the savvier investments you'll likely make, and the more comfy your retirement will be.

Here at The Motley Fool, we've long believed in the power of education, and this season we're once again supporting an impressive charter school, Thurgood Marshall Academy, in a poverty-stricken part of our nation's capital. A remarkable 100% of its graduates have been accepted into colleges!

Join us as we support Thurgood Marshall Academy and its deserving students. Take a few minutes to learn about the school, and consider sending it a donation. And for every comment you leave on a Fool article or message board through Jan. 7, we'll send the school $0.10, up to $20,000. You can boost your own financial knowledge, and advance the futures of hard-working kids, in one fell swoop

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Charles Schwab is a Motley Fool Stock Advisor selection. The Fool owns shares of Altria Group. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.


Read/Post Comments (2) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 01, 2010, at 10:16 PM, targetphil2 wrote:

    cha-ching!

  • Report this Comment On December 02, 2010, at 10:00 AM, jessjdc wrote:

    Thanks to all readers! You're helping students at TMA gain important financial knowledge and life skills. --TMA staff member

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1385685, ~/Articles/ArticleHandler.aspx, 8/23/2014 11:33:26 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement