If you are a savvy saver, then you can skip this week’s column. If not, then let’s see how much you know about three basic principles of saving money: compounding, inflation, and risk. If you dare to compare yourself to the average American, then answer the three questions used in a research project by Olivia Mitchell of the Wharton School and Anna Maria Lusardi of George Washington University. Only one-third of Americans over 50 answered all three questions correctly.
Question 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. D) Do not know/Refuse to answer."
Question 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. D) Do not know/Refuse to answer."
Question 3: "Please tell me whether this statement is true or false: Buying a single company's stock usually provides a safer return than a stock mutual fund."
Write down your answers and read on. Question 1 addresses your understanding of compound interest. The correct answer is “A) More than $102.” That’s because the account earns $2 in the first year, then 2% of $102 in the second year, etc., until after five years the account is worth $110.41.
Question 2 digs into your understanding of a “real” rate of return compared to a “stated,” or “nominal,” rate of return, and how the difference relates to your future purchasing power. The stated rate of return is 1% per year, so after one year, $100 would grow to $101. Now let’s assume that the groceries you buy at the beginning of the year cost $100, and inflation is 2%. At the end of the year, the cost for the same basket of groceries would be $102. So the answer to question 2 is “C) Less than today.” And in case you are wondering, in this example the “real” return is a negative 1%.
Question 3 provides insight into what you know about investment risk. Savvy investors know the statement is false and that a stock mutual fund contains many stocks, and that if one of those stocks becomes worthless, the mutual fund will still have value. On the other hand, buying a single company’s stock is risky. Any company, no matter how safe you think it is, can go “belly up.” A great local example in Monterey County involved the publicly traded shares of Pacific Capital Bancorp, the holding company for First National Bank, a popular local bank for many years. Some Monterey County residents who were shareholders in the bank watched helplessly as their retirement savings went down the drain when the share price dropped from over $20 to less than $1 in 2009.
The bottom line is Americans need to be better educated on personal finance. In my opinion it should start in lower school along with the three “Rs” and continue on through High School. Every High School Graduate, and even every 50 year old, should be able to answer the three questions correctly.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.