It's not a big secret that Americans are lacking in financial literacy. In fact, in one 2015 international study of 15-year-olds, the U.S. ranked 12th out of 18 participating countries for financial literacy skills, and according to many other surveys and tests, our adults aren't doing too much better. To illustrate this, here are five questions about investing and retirement planning, all of which were answered correctly by less than half of the American adults who responded to them.
1. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
This question is included on FINRA's financial literacy test (which you can take here), and according to the agency's most recent report (2015), only 28% of respondents got this question right. Thirty-three percent chose one of the wrong answers, and 38% answered "don't know."
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The correct answer is that when interest rates are rising, bond prices typically fall. As a simplified example, let's say that you pay $1,000 for a 30-year Treasury bond that pays 4% interest, or $40 per year. Now, let's say that a couple of months later, the market interest rate for 30-year Treasury bonds jumps to 5%. Because investors are now expecting higher yields from their investments, you'll need to give a prospective buyer a discount in order for your $40 annual interest to translate to a 5% effective yield.
I'll spare you the mathematics of how this works, but according to a bond calculator, the value of your Treasury bond would plummet to just $845 in this scenario.
2. Buying a single company's stock usually provides a safer return than a stock mutual fund. True or false?
This is another FINRA question, and it had a somewhat higher success rate than the first one. Still, 54% of respondents either didn't know the answer or gave the incorrect response.
The correct answer is "false." In fact, one of the primary reasons to purchase a mutual fund is to spread your money around among many different stocks in order to diversify your holdings. To be sure, some stocks are more volatile than others; however, as a rule, investing in a single stock is a bad idea because of the lack of safety this strategy produces.
3. How often over the past 35 years do you think the market has had a positive annual return?
This question, as well as the two that follow, came from a Fidelity survey released earlier in 2017.
Since only 8% of survey respondents were able to correctly answer this one, it might surprise you to learn that the stock market has produced positive returns in 30 of the past 35 years. The point of this question is to show that while the stock market won't always go up, it certainly has more positive years than negative ones. This is why it's so important for investors (even conservative and retired investors) to keep at least some of their assets in stocks, as they provide the best opportunity for long-term growth.
4. If you were able to set aside $50 each month for retirement, how much could that end up becoming 25 years from now, including interest, if it grew at the historical stock market average?
Only 16% of respondents were able to estimate the correct answer of "about $40,000." Nearly half underestimated the amount, and more than one-fourth dramatically lowballed the answer, saying that it would only produce "about $15,000." This is another example of the long-term compounding power of the stock market, and it goes to show that seemingly small increases in your retirement savings can have quite a large impact over long periods of time.
5. About what percentage of your savings do many financial experts suggest you withdraw annually in retirement?
Fidelity's survey respondents did decently on this one. Forty-two percent of the pre-retirees surveyed answered correctly with a range of 4%-5%. This makes sense, as the "4% rule" of retirement is a rather popular concept.
The alarming thing is the number of people who overestimated how much they can safely withdraw. Thirty-eight percent said that 7% or more of their savings was a safe amount to withdraw annually, and 15% said that 10%-12% was a safe withdrawal rate. Taking this much out of your savings in retirement every year and increasing it for cost-of-living purposes is a good way to run out of money. In fact, in the current low-interest environment, more and more retirement experts have begun suggesting that even 4% is too ambitious.
The Foolish bottom line
You may have heard that Americans aren't saving enough for retirement, and that's definitely true. Increasing our financial literacy by understanding topics like those mentioned above is the key to knowing not only how much we should be saving, but how to invest our savings properly and use our nest eggs appropriately after we retire.
