Why is financial literacy so critical? Because each of us is accountable for overseeing our own financial affairs and results. This is true whether you manage most of your affairs or outsource them to an adviser.
Here’s our take on what needs to be understood to be financially literate.
– Effect of inflation
– Compound interest
– Equities vs. fixed income
This is the rate by which the cost of goods increases. The most common measurement is the Consumer Price Index (CPI). Here’s an example of how this works. Let’s say that you spent $3,000 in 2013 for gas, groceries and electricity in total. If the CPI is 3%, then you can expect to pay $3,090 ($3,000 X 1.03%) in 2014. (Note that this is for illustrative purposes only.) The lesson learned is that the affect of inflation has to be factored into our various financial calculations.
Compound interest refers to the affect that interest rates have on an investment. If your bank pays 2% per year for your deposit of $1,000, then your investment is worth $1,020 at year end. At the end of year two, your initial $1,000 would now be worth $1,040 ($1,000 * 1.02% =$1,020; $1,020 * 1.02% = $1,040).
Equities vs. Bonds
This is important to understand because it is fundamental to investing. Equity is money that you invest. Examples include stocks and down payments on houses. Some companies may pay dividends but it is at their sole discretion. Dividends are a return of capital to stock holders and are usually paid once a quarter. Bonds refer to money that you loan. When you buy a treasury bond or a corporate bond, you are loaning the borrower (e.g. the US Government or a corporation) a sum of money that they promise to pay back on an agreed to date. The borrower agrees to make interest payments to you to compensate you for “renting” your money to them.
Here’s a brief comparison of stocks vs. bonds.
- Stocks are considered to be more risky than bonds. In the event of a corporate bankruptcy, bondholders are paid before stockholders.
- Stocks are better hedges against rising interest rates and inflation. This is because companies have the ability to raise their prices and therefore their earnings which are highly correlated with a stock’s price.
- The amount of interest that a bond yields is affected by the stability of the company and the length of time that the money is loaned for. The longer the duration of the loan, the higher the interest rate. That is referred to as interest rate risk, i.e. borrowers receive more interest for a longer duration bond to compensate them for accepting greater risk simply based on the premise that the chances of bad things happening increase over time.
- Many financial professionals encourage a higher percentage of investments in stocks when people are younger. However, more and more financial professionals advise retirees to maintain some investment in stocks to help guard against the risk of outliving your savings.
- Both bond interest and stock dividends are popular and common means for retirees to obtain unearned income.
- US Treasuries are considered to be the least risky investment available.
This refers to you acting as the borrower. Typical lenders include credit card companies, banks and or financial entities. When you borrow money, you enter into an agreement that includes repayment terms. These terms include the loan duration, interest rate (that you will have to pay) and the frequency. There are many situations where it makes good financial sense to borrow: for a home, a car, furniture or a home improvement project. On the other hand, there are many situations where the use of credit is risky: buying stocks on margin, a home equity loan, using a credit card that carries a high interest rate to pay for non-discretionary expenses.
This refers to the process of comparing your income vs. your expenses. It is a discipline that helps you to control and manage your spending and savings. It is such an important component that it is covered in its own section. Click here to jump to that section.
Diversification is the means to balance investment risk vs. return. Diversification is often expressed as the percent of your investments held in various asset classes. For example, 50% in stocks, 40% in bonds and 10% in cash. The adjustment of these investment ratios should vary along the way of your retirement journey.
The process of becoming financially literate is probably like trying to learn a language. It gets harder as you grow older. But that is not reason to give up or not even try. The payoff, a financially successful retirement, is worth the effort regardless of whether you manage most of your own financial affairs or outsource as much as you can. And keep in mind, when all is said and done, you are responsible for the route that your financial journey follows, where and how it ends.
- You need a fundamental understanding of finance if you outsource the vast majority of your financial affairs to an adviser.
- You are ultimately accountable for your financial results and to not become a victim of fraud.
- Managing your finances requires building a financial team.
- The more of your own financial affairs that you manage yourself, the greater your level of understanding needs to be.
- It is necessary to continue the learning process. Here are some of the ways that we do so.
- Attend seminars from our financial institution
- Attend ad hoc seminars on topics such as social security
- Listen to business podcasts and read finance and investment related books.
- Visit financial websites.
- Watch CNBC and Bloomberg