Financial literacy still eludes many
What have we learned since the financial crisis and Great Recession? Not so much, according to research from the FINRA Investment Education Foundation.
In its study “Financial Capability in the United States 2016,” the percentage of respondents who were able to answer at least four out of five financial literacy quiz questions correctly, has fallen slightly since 2009.
The questions covered what FINRA thought respondents might run across in their day-to-day lives, like concepts involving interest rates and inflation, principles relating to risk and diversification, the relationship between bond prices and interest rates, and the impact that a shorter term can have on total interest payments over the life of a mortgage.
And the survey says? Only 14 percent of respondents were able to answer all five questions correctly and just 37 percent answered at least four questions correctly. In addition, people overestimated their financial knowledge.
Seventy-six percent of respondents gave themselves high marks, but “less than two-thirds (64 percent) are able to do two simple calculations involving interest rates and inflation, and only 40 percent are able to correctly calculate compound interest in the context of debt.”
You might think that the answer to these dismal results is to amp up financial literacy efforts, but research suggests education alone may not lead to better financial choices. A separate study commissioned by the Consumer Financial Protection Bureau and conducted by the Urban Institute found that “many consumers need more than access to information; they may also need someone to help them to identify and achieve their financial goals and take action on financial plans. A financial coach can serve as a capable and trusted guide to help consumers navigate those decisions.”
The most vexing question for respondents of the FINRA survey related to the amount of time it would take for debt to double, “illustrating that many Americans simply do not understand the potential power of compounding.”
One of the easiest ways to think about compounding is to review the “Rule of 72,” a way to figure out the number of years required to double your money at a given interest rate. For example, if you want to know how long it will take to double your money at six percent interest, divide 72 by six and you get 12 years. You can also use the Rule of 72 to think about debt. If you pay 15 percent interest on your credit cards, the amount you owe will double in 72/15 or 4.8 years.
Although compounding was tough for respondents, the worst performance on the FINRA study was a question about how bond prices respond to rising interest rates. Only 28 percent of people answered that one correctly.
You may have heard that “bond prices move inversely to interest rates” — here's why. If you own a 10-year U.S. government bond that is paying 5 percent, it will be worth more now, when new bonds issued by Uncle Sam are only paying 1.8 percent.
Conversely, if your bond is paying 2.5 percent and your friend can purchase a new bond paying 5 percent, nobody will be interested in your bond and the price will fall. That's why bond prices move in the opposite direction of prevailing rates, regardless of the bond type.
So, if interest rates are on the rise, it is likely that your individual bond or bond mutual fund will drop in value.
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