Citi Wharton: Three Questions that can Help You Invest Better

Some people mismanage their budgets, invest unwisely, spend too lavishly and don’t save enough for retirement – while others fare much better in managing their finances. What drives these differences?

Wharton professor Olivia S. Mitchell and George Washington School of Business professor Annamaria Lusardi ran a study that asked respondents three simple questions about compounding, inflation and risk. Most of the people queried were stymied by at least one question.

The three questions were:

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.

   (Answer: More 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.
   • d. Do not know/Refuse to answer.

   (Answer: Less than today.)

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.
   (Answer: False.)

In the United States, only half could get both of the first two questions right, while only one-third answered all three correctly. Not just in the U.S., the professors also 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 poorer in Russia and Romania.

While people with more education did better, their results were also not impressive. Less than 50% of those with college degrees answered all three questions correctly.

Mitchell and her co-authors have found that one-third of wealth inequality can be explained by the financial-knowledge gap separating the well-to-do and the less so.

In a new paper, "Financial Literacy and Economic Outcomes: Evidence and Policy Implications," Mitchell and Lusardi found that people who get any of the three questions wrong are unlikely to master trickier challenges which include choosing the right investments for retirement.

According to the researchers, people who do not understand the principles of interest tested in the first question are unlikely to benefit from savings and investing over long periods. They might also underestimate the snowballing effects of even slight changes in investment returns – or of reinvesting rather than spending interest and dividends from bank accounts, stocks or mutual funds.

Those who get the inflation question wrong may think they can retire on less than they will actually require, getting a false sense of security from accounts that are growing but not as fast as prices.

Meanwhile, those who don't understand that a single stock is riskier than a diversified mutual fund run the risk of putting too much money into a single stock.

According to the writers, research shows that financial knowledge correlates with better outcomes – the financially savvy tend to take on less credit card debt and pay balances off each month. They’re more likely to refinance a mortgage when it is profitable to do so, are less likely to fall prey to high-cost debt like payday loans and are more likely to plan for retirement.

From Knowledge@Wharton. Feb 11, 2015. The original article can be found at http://knowledge.wharton.upenn.edu/article/three-questions-major-implications-financial-well/