Try this quick quiz:
Question 1: Suppose you had ₹100 in your savings account today and the interest rate is 8% per year. After five years, how much do you think you would have in the account if you left the money untouched?
- A] More than ₹108 B] Exactly ₹108 C] Less than ₹108
Question 2: Imagine that the interest rate on your savings account was 8% per year and inflation was 9% per year. After one year, how much would you be able to buy with the money in this account?
- A] More than today B] Exactly the same C] Less than today
Question 3: Buying a single company’s stock usually provides a safer return than a stock mutual fund. True or False?
Did you find them ridiculously simple? If yes, congratulations! You’re one of the few who is likely to build significant wealth over the long term using the concepts of investing.
The Wharton school and the Pension Research Council conducted research over a period of 10 years, which involved asking respondents the three questions above. They test awareness of basic concepts of inflation, compounding and diversification.
The finding: Fully one-third of wealth inequality can be explained by the financial knowledge-gap separating the wealthy and the not-so-wealthy
Let that sink in for a minute. The researchers suggest that understanding concepts as basic as inflation and compounding can have a telling impact on financial prosperity over a lifetime.
The research goes on to say that roughly 50% of Americans got the first two questions right while only a third got all three right. This finding held even when the geographic scope was extended to include other wealthy countries.
“Again to our dismay, however, we found widespread financial illiteracy even in relatively rich countries with well-developed financial markets such as Germany, the Netherlands, Switzerland, Sweden, Japan, Italy, France, Australia and New Zealand. Performance was markedly worse in Russia and Romania.”
Education levels did have an impact on how well people answered these questions. Over 3 out of 5 post-graduates got all three questions right while just one in ten of those who did not have a high-school degree got them right.
Another finding of the research was that “men tend to be more financially literate than women”.
However, the add-on to that from other studies is that women are more likely to recognize their shortcomings and be open to learning when it comes to financial decision-making as opposed to men who tend to confident, even when wrong. Talk about ignorance is bliss.
I’m not sure how India would do if it were part of this research. Would we out or under-perform the developed countries? A misplaced sense of pride might overstate our guesses, but given the abysmally low penetration of equities and the still-strong obsession with real estate as an investment vehicle, I wouldn’t bet on the result.
While knowledge of arcane financial concepts are not a must for financial health, being unaware of the basic concepts of inflation and compounding can mean a lifetime of poorly thought out financial decisions which have a material impact on your net worth.
The good thing is it’s never too late to start to be a regular investor who invests, first to beat inflation and second, to grow his/her wealth over the long-term.
Here are a few articles to get you started. Call it a “back-to-basics guide to investing”:
1. Why bother with investing at all? Short answer: Inflation
- Read: Why do we invest?
2. The most powerful force in investing – Compounding
- Small amounts invested early and regularly with modest returns snowball into significant savings over time
3. Why equities over other asset classes?
4. What moves stock prics in the long term?
- Therefore, a “fair value” for a stock depends on the market’s projection of future business performance
5. When it comes to investing, SIP don’t guzzle
- Hence, when it comes to investments, Read: SIP don’t guzzle
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