By Kevin K.M. Neoh
If a person is unable to read or write, we say this person is illiterate. Likewise, a person who is unable to understand personal finance and how money works is said to be financially illiterate.
In 2002, the Organisation for Economic Co-operation and Development (OECD), an intergovernmental economic organisation with 36-member countries, officially recognised the importance of financial literacy. It launched a comprehensive financial education project worldwide and in 2008, further enhanced it with the OECD International Network on Financial Education (INFE).
Financial Literacy Defined
The OECD-INFE defines financial literacy as, “a combination of awareness, knowledge, skill, attitude and behaviour necessary to make sound financial decisions and ultimately achieve individual financial wellbeing.”
Personally, I think a majority of us still lack awareness. We do not have adequate knowledge or have the skill level to manage our wealth and our attitude and behaviour are also skewed towards living in the present without properly planning for the long term. This leaves many of us vulnerable. Not having the ability to properly care for our own financial wellbeing is detrimental to our potential and dangerous to our future financial security. We may live to regret this when we age.
There is a simple test designed by A. Lusardi and O. Mitchell in 2004 known as the “Big Three” in financial literacy questions. The Big Three is used to measure one’s knowledge of key concepts in smart financial decision-making.
The Big Three Questions
1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?
A. More than $102
B. Exactly $102
C. Less than $102
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% 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
3. Is this statement True or False? Buying a single company’s stock usually provides a safer return than a stocks mutual fund.
If you are unsure, the answer to Question 1 is A, answer to Question 2 is C, and for Question 3, is B.
Evidently, Question 1 tests a person’s understanding of compound interest, ie interest earning interest; whereas Question 2 is about our understanding of the impact of inflation over our purchasing power; and Question 3 is about the concept of diversification (not putting all eggs into one basket).
These three questions basically cover the concept of saving and investing. If we understand basic concepts like how our money earns interest and how compound interest works, what inflation is, how it erodes our purchasing power, and how investing into one single stock can be riskier compared to investing in a basket of stocks, this understanding will help one go a long way in making smart decisions about savings and investments.
Consequences of the Lack of Awareness
A person who is not aware of the wonders of compounding interest will not necessarily have the awareness about importance of saving money, much less investing early.
Likewise, a person who does not understand the concept of inflation and the existence of inflation may be comfortable keeping money in a savings account and be contend, missing out the opportunity to allocate their cash or savings into instruments or assets that can help to hedge against inflation.
Sometimes, we might even be investing our money in low-yield instruments but our investment goal or objective may require a higher yield to offset the effect of inflation. For example, if inflation of my lifestyle is about 6% pa; it makes no sense for me to invest my retirement savings or long-term money in a portfolio that is yielding 5% pa, as over the long-term, my nest egg will not catch-up with my cost of living.
Knowing When to Buy and Sell
Of course, holding on to a single stock actually has higher risks as opposed to holding on to a portfolio of multiple different stocks. Imagine making an investment into a company that has shown promising growth over the past few years, where the stock price has grown multiple times but today, due to a lack of innovation, or deteriorating management qualities, or competition or simply regulatory changes, this company has lost its edge and is faced with increased in cost.
A combination of factors could erode a company’s bottom line and a shrinking bottom line is likely to be reflected in its share price. Hence, it is riskier compared to a person who invests in multiple stocks or say via a mutual fund which typically contains about 30 stocks in holding; or an exchange-traded fund (ETF) which is like investing in the constituents of an index.
Which Asset Class is Best?
Of course, we also tend to have friends or acquaintances who have made profitable investments and they share with us how they made it and with which asset. Often, we hear people say they make their fortunes via property, and one should only invest in properties. Another time, we may hear of people who say investing in stocks is best. Yet, some other time, others may argue that investing in commodities like gold and silver are better than anything else. If truth be told, each asset class has its own good and bad, depending on the economic cycle and inflationary environment. We need to practice proper asset allocation to have our portfolio consist of each of the asset classes to ensure that our wealth can withstand the “weather” of uncertainty in the market.
Financial literacy is perhaps one of the key factors that will help a person make quality financial decisions and since we do not get to learn about this in school, it is obvious we must take initiative to teach ourselves.