Are You Financially Literate?

Each year the month of November is designated as Financial Literacy Month. I like to think that each blog post that I write adds to the financial literacy of my readers, but there is something to be said for a special focus on bringing up the level of basic financial understanding among Canadians.

 

What is Financial Literacy?

According to the definition provided by the Financial Consumer Agency of Canada, “Financial literacy includes the skills and capacity to make informed financial decisions, as well as actions or behaviours that lead to positive financial outcomes. Financial literacy is considered an essential skill, like reading and writing.”

 

Is Financial Literacy Legitimate?

I will admit to some hesitancy to jump on the “FinLit” bandwagon. Or rather, I question the sincerity of some of the financial literacy participants. In my opinion, some are bad actors who try to exploit consumer financial illiteracy in their “day jobs.”

 

For example, some industry representatives argued vociferously against the proposed elimination of Deferred Sales Charges (DSC) for mutual funds sales representatives. When that step was nevertheless taken, many of the firms that sold mutual funds shifted their investment emphasis to segregated funds, which are essentially mutual funds with certain insurance guarantees built in, which still allowed for the DSC option. Elimination of the DSC option is now on its way in the segregated fund world and again there is resistance.

 

Global Financial Literacy

Nevertheless, there are some fundamentals that every person with money should be aware of. A survey by the Global Financial Literacy Excellence Centre sought to assess the degree of financial literacy in four areas: Risk Diversification; Inflation; Numeracy; and Compound Interest.

 

Before getting into these questions, however, I will present a few statistics on financial literacy, courtesy of a video by Ben Felix, portfolio manager at PWL Capital. He also provides a slightly more expansive definition of financial literacy: “People’s ability to process economic information and make informed decisions about financial planning, wealth accumulation, debt, and pensions.”

 

Financial Illiteracy

• Approximately 2/3 of the world is financially illiterate.
• Approximately 1/3 of Canadians are financially illiterate.

 

Financial Literacy

Financially literate households are more likely to:

 

• Plan for retirement
• Have retirement savings
• Invest in higher-expected-return assets like stocks, and
• Avoid high-cost debt

 

Retirement Wealth Inequality

In a study conducted in the United States, an estimated 30-40 percent of inequality in retirement wealth can be accounted for by differences in financial knowledge.

 

How the Less Financially Sophisticated Invest

• They are less likely to invest in the stock market
• When they do invest:
  • They show stronger behavioural biases;
  • Hold a lower share of their portfolio in risky assets;
  • Hold under-diversified portfolios;
  • Tilt their portfolios toward volatile stocks, often referred to as “lottery stocks”; and
  • Have a greater bias toward home-country stocks and the stock of their employers.

 

Education Does Not Equal Financial Literacy

• Financial literacy is a distinct form of education that contributes to financial outcomes beyond academic education.
• There is often a mismatch between people’s self-assessed financial knowledge and their actual knowledge.
• The financially illiterate are much more likely to own cryptocurrencies.

 

Financial Literate People are More Likely to:

• Engage in retirement planning and thereby accumulate more retirement wealth

 

People with Low Financial Literacy are More Likely to:

• Have low financial well-being as measured by:
  • Control over day-to-day finances;
  • Financial freedom to make choices to enjoy life;
  • Capacity to absorb a financial shock; and
  • Being on track to meet financial goals.

 

The Financial Literacy Survey

If you are a regular reader of my blog, I believe that you will be able to score yourself as financially literate. The answers and explanations are below the five questions.

 

1. Suppose you have some money. Is it safer to put your money into one business or investment or to put your money into multiple businesses or investments?
   1. One business or investment
   2. Multiple businesses or investments
   3. Don’t know

 

2. Suppose over the next 10 years the prices of the things you buy double. If your income also doubles, will you be able to buy less than you can buy today, the same as you can buy today, or more than you can buy today? (Ignore taxes in your answer.)
   1. Less
   2. The same
   3. More
   4. Don’t know

 

3. Suppose you need to borrow 100 dollars. Which is the lower amount to pay back: 105 dollars or 100 dollars plus three percent?
   1. 105 dollars
   2. 100 dollars plus three percent
   3. Don’t know

 

4. Suppose you put money in the bank for two years and the bank agrees to add 15 percent per year to your account balance. Will the bank add more money to your account the second year than it did the first year, or will it add the same amount of money in both years?
   1. More
   2. The same
   3. Don’t know

 

5. Suppose you had 100 dollars in a savings account and the bank adds 10 percent per year to the account balance. How much money would you have in the account after five years if you did not remove any money from the account?
   1. More than 150 dollars
   2. Exactly 150 dollars
   3. Less than 150 dollars
   4. Don’t know

 

Survey Answers

1. b
2. b
3. b
4. a
5. a

 

Survey Explanation

Risk Diversification. The saying “don’t put your eggs in one basket,” applies to investing. Diversifying your investments across multiple categories is the proverbial “free lunch” in the investment world. The broadest categories are cash, fixed income, and equity.

 

• Cash can include savings accounts and, depending on how you look at it, Guaranteed Investment Certificates (GICs, or CDs if you live in the US).

 

• Fixed income as an investment is often synonymous with bonds. Your possession of a bond represents a debt owed to you, or in other words, a loan to the borrower. You can diversify by buying bonds from governments or corporations. You can also buy bonds that will mature within 1 or 2 years to bonds that mature in 30 years. Bonds also vary in quality. Lower-quality bonds will pay higher interest than bonds of a similar maturity that are of greater quality.

 

• Equity investments are typically referred to as stocks or shares and can be bought from small companies to mega companies, from railways to banks to mining companies to telecommunication companies, and many more. Loading up on the stock of five different banks in Canada is not diversification. Rather, it exposes you to risks that you don’t want to take. Financial academics argue that you should seek broad exposure to the universe of stocks – Canada, the United States, International stocks from the markets of developed countries around the world, as well as stocks from the world’s Emerging Markets. This allows investors to obtain the so-called systematic “risk premium” of investing in the entire basket of available stocks. This is also known as compensated risk. However, investing in a narrow or undiversified range of stocks will expose the investor to unsystematic or idiosyncratic risk that tends to be uncompensated.

 

Inflation. Understanding inflation is important because the decreasing purchasing power of cash over time can be damaging. While this question refers to income matching inflation, this question also applies to investing. Many people prefer to avoid investing in risky assets. You can go into your local bank branch and open an RRSP that will hold your entire contribution in a savings account earning 0.01%. Here the risk is not that of losing your money in a risky investment; it is that you will lose your purchasing power over time.

 

Certainly, there can be legitimate reasons to hold a portion of your RRSP assets in cash, especially if you plan to withdraw part of the account in the coming year, but if you have decades to go before you plan to withdraw from your RRSP, not investing in risky assets is likely an even riskier gamble. Getting $1 per year on a $10,000 contribution to your RRSP is not going to help you at all when you will need to live on your RRSP assets in your 60s, 70s, 80s, and quite probably your 90s. Recognizing the corrosive effect of inflation on your assets is one of the first steps to recognizing the value of investing in assets like stocks that have the long-term potential to exceed inflation. This insight probably also explains why the more financially literate are more likely to invest in stock or equity investments.

 

Numeracy. As literacy refers to the ability to understand letters, that is, that you can read, so numeracy is the ability to understand and use numbers. That includes understanding percentages. Question 3 tests numeracy by seeing whether the test-taker can recognize that paying back $105 after borrowing $100 is more than paying back $100 + 3%, which is $103. While not particularly challenging, it is essential that Canadians have at least basic numeracy skills to function in Canadian society.

 

One example of how an awareness of percentages can help you is in borrowing. Credit cards routinely charge 20% interest. The long-term average return of a stock portfolio is likely in the 6 to 7% range. Numeracy would help an investor recognize that holding a $10,000 investment that returns 7% per year while simultaneously owing $10,000 on a credit card that charges 20% per year is a losing proposition.

 

Another instance of innumeracy that should serve as a cautionary reminder of the value of basic math was the failure of A&W Restaurant’s attempt to compete with McDonald’s Quarter Pounder burger. In the 1980s, A&W heavily advertised their new Third Pounder burger, which they sold at the same price as the Quarter Pounder. After hiring a market research firm to find out what went wrong, they found that about half of those surveyed believed that a 1/3 was less than 1/4…

 

Compound Interest. The last two questions both cover compound interest and according to the testing methodology, test-takers only needed to get one of the last correct to get a point for this topic.

 

Following test question #4, let’s suppose you deposit $100 in the bank account at the beginning of the first year. A year later the bank deposits $15 in the account, which is what 15% annual interest will get you. You now have $115. Since the bank agreed to pay you 15% per year and the bank account had $115 at the beginning of the second year, 15% will be multiplied by $115, which means at the second year you will receive $17.25 ($115 x 15%), which is more than you received in year one.

 

The fifth question builds on the fourth. The answer, more than $150, is correct and reflects the power of compounding. How much would you have after five years? The following table illustrates the impact of compounding.

 

 

You begin your five-year investing journey with $100. In the first year you earn 10% or $10 so that, at the end of year 1, you have $110. In the second year, you again earn 10%, but this time on $110, so you earn $11 in interest. And so on, until at the end of five years, you have, not $150, but more than $150 or $161.05 to be exact.

 

These last two questions illustrate the root of financial investing success, and often, financial borrowing failure. When you have money, your money makes more money. When you owe money, the interest charged compounds and you owe more money.

 

Understanding the impact of compound interest, numeracy, inflation, and diversification can make a tremendous difference in your financial situation. If this is an area in which you struggle, perhaps this little test will help you on your way to more effective use of your money.

 

This is the 174^th blog post for Russ Writes, first published on 2022-11-28.

  

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.

Photo by Magda Ehlers