The Importance of Financial Literacy

Learning some basic investing concepts can set you up for a much richer retirement.

Aug 28, 2014 at 9:08AM

Financial literacy is something we can benefit from at all stages of life. From saving for a college education to getting by in retirement, many people today are feeling extreme financial anxiety and are looking for answers.

Unfortunately, many Americans are unfamiliar with even the most basic economic concepts needed to make saving and investment decisions. In fact, research shows that more than half would fail a basic finance quiz. This lack of financial knowledge presents serious barriers in home purchases, retirement planning, and other financial choices.

A well-informed consumer is critical to a strong and stable economy. While there are no guarantees or one-size-fits-all solutions to every monetary situation, knowing a few fundamentals could do wonders for your finances and your peace of mind.

Spending versus saving
Over time, your savings can make a large difference in your future financial lifestyle. Paying attention to how you spend your money will reveal opportunities to cut back. However, savings should be the money you set aside before you spend. In short, you need pay yourself first. Make it easy by setting up automatic contributions from each paycheck to your retirement savings account.

Thinking of personal savings as the first bill you pay is an easy way to help build your savings gradually. If you are consistent, no amount is too small to make a difference. Regular contributions also help you take advantage of compound interest.

Compound interest is interest earned on interest. For example:

Let's say you have $1,000 and it earns an 8% return annually. At the end of 10 years, it will have grown to $2,158.92, even if you never added another penny to it. This assumes that you do not withdraw investment earnings or make any additional contributions.

Note how your balance would grow exponentially over time:

Year

Future Value Without
Additional Contributions

1

$1,080.00

2

$1,166.40

3

$1,259.71

4

$1,360.49

5

$1,469.33

6

$1,586.87

7

$1,713.82

8

$1,850.93

9

$1,999.00

10

$2,158.92

Retirement planning
Baby boomers -- those born between 1946 and 1964 -- are now beginning to retire en masse. In the Employee Benefit Research Institute's 2013 Retirement Confidence Survey, workers aged 55 and older said the following about their retirement savings:

  • 60% have less than $100,000 in retirement savings
  • 43% have saved less than $25,000
  • 36% have saved less than $10,000

Pretty scary, huh? What we can learn from this, though, is the sooner you start investing for retirement, the better. Thanks to an investment strategy known as dollar-cost averaging, you can get into the market at a predetermined schedule that feels comfortable. Coupled with the effects of compound interest, a plan for entering the market can be a strong ally in the quest to reach your retirement goals.

Dollar-cost averaging is a simple practice by which you put a set amount of money into your investment and retirement accounts each month. When you set up a 401(k) at work that automatically puts money into the account directly from your paycheck, you're using dollar-cost averaging -- even if you don't realize it. 

Here's an example: Let's say you invest $2,000 in a mutual fund over the course of five months. Using dollar-cost averaging, you could plan to make five monthly investments of $400 each, buying shares at both highs and lows. At the end of five months, you own 150 shares that cost you $2,000. 

Monthly Investment

Share Price

Shares Acquired

$400

$14.28

28

$400

$13.33

30

$400

$12.50

32

$400

$12.90

31

$400

$13.79

29

$2000

 

150

Dollar-cost averaging not only makes investing low-effort and habitual, but it also enables you to take advantage of price dips. In this example, buying $2,000 worth of shares in the first month at $14.28 per share would have resulted in only 140 shares, whereas using dollar-cost averaging over the course of the five-month period (during which you purchase shares at varying prices) netted you 150 shares at an average price of $13.36 per share. That's 10 additional shares worry-free because you automatically spread out your purchases.

Financial knowledge and decision-making
Figuring out which investing strategy works for you can be intimidating, as the investments you choose help determine whether or not you achieve your financial goals. But before you randomly make choices, take some time to think about your risk tolerance -- that is, your ability to withstand swings in the value of your investments. Your risk tolerance should take into account your specific goals, your time horizon for each goal, your additional financial assets, and the stability of your job. Revisiting your risk tolerance as your circumstances change is important to help ensure your portfolio is best suited for your situation.

Having some basic financial know-how can help you make the best decisions regarding your money and retirement. If you're feeling overwhelmed by loads of information or would like a professional to guide you through the process, reach out to a qualified fee-only advisor. They can help make sure you're on track to affording the retirement you want.

How to get even more income during retirement
Social Security plays a key role in your financial security, but it's not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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