I bet you can’t answer all these six simple questions

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Then try taking the following financial literacy test which contains just three basic questions about interest rates, inflation, and diversification. Although they are fairly basic, only 34% of adults aged 38 to 64 are able to answer all three correctly. Among millennials, this percentage is only 16%.

These results give food for thought. But what is even more striking is the disconnect between these low scores and the self-perception of investors. Over 71% of seniors rate themselves as having “good financial knowledge”. The comparable percentage among millennials is only slightly less than 62%.

These results are reported in a recently published study, “Millennials and Money: Financial Preparation and Money Management Practices Before COVID-19. “Its authors, all affiliated with the Global Financial Literacy Excellence Center at George Washington University, are Annamaria Lusardi (founder and director of the Center), Andrea Hasler and Andrea Bolognesi.

Here are those three basic questions for which researchers report “shocking” levels of financial literacy. They were designed a decade ago by Lusardi and Olivia Mitchell, a professor at the Wharton School at the University of Pennsylvania, and have been so widely used since then that many researchers now call them the ‘big three’ of literacy. financial. (The correct answers, if in doubt, are listed at the end of this column.)

• Suppose you have $ 100 in a savings account and the interest rate is 2% per year. After five years, how much do you think you would have in your account if you let the money grow? [More than $102; Exactly $102; Less than $102; Don’t know; Prefer not to say]

• Imagine your savings account’s interest rate is 1% per year and inflation is 2% per year. After 1 year, how much could you buy with the money in this account? [More than today; Exactly the same; Less than today; Don’t know; Prefer not to say]

• Buying shares of a single company generally offers a more secure return than a mutual fund. [True; False; Don’t know; Prefer not to say]

Since you are regular readers of MarketWatch and subscribed to Retirement Weekly, I have no doubt that you answered all three questions correctly. But can you also answer the following three bonus questions? Only 7% of seniors could answer all six questions correctly, and only 3% of Millennials. These three additional questions are:

• If interest rates rise, what will generally happen to bond prices? [They will rise; They will fall; They will stay the same; There is no relationship between bond prices and the interest rate; Don’t know; Prefer not to say]

• Suppose you owe $ 1,000 on a loan and the interest rate you are charged is 20% per year, compounded annually. If you paid nothing at that interest rate, how many years would it take for the amount you owe to double? [Less than 2 years; At least 2 years but less than 5 years; At least 5 years but less than 10 years; At least 10 years; Don’t know; Prefer not to say]

• A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less. [True; False; Don’t know; Prefer not to say]

There are several reasons to focus on the number of people who can answer these questions correctly. Most importantly, there is a direct causal link between illiteracy and reduced financial security in retirement. This has been shown empirically, as in this study by Lusardi and Mitchell. The authors of this recent report give a few examples, including the widespread use by millennials of “alternative financial services”.

“Alternative financial services are forms of short-term borrowing that fall outside the traditional banking sector. This includes borrowing through auto title loans, payday loans, pawn shops, and rental shops with an option to buy. These are particularly expensive forms of borrowing, with APRs reaching 400% or more, and as such have been defined as high cost methods of borrowing. In 2018, 43% of millennials reported using at least one form of alternative financial service in the [prior] five years.”

This surprising reliance on expensive methods of borrowing becomes less surprising when we focus on Millennials’ answer to the second of the above bonus questions, which is about compound interest. Only 32% of them could answer it correctly. Researchers found that higher levels of financial literacy correlated with lower reliance on alternative financial services.

Another reason to focus on financial literacy is to warn yourself about the dangers of overconfidence. Chances are, you judge your financial literacy to be higher than it actually is. And overconfidence leads to particularly risky behavior.

The moral of the investment I take from this new report is the importance of using the services of a financial expert in retirement. Having someone to kick off your ideas with is a great way to make sure you haven’t built your retirement financial security on a shaky foundation. Having this reality check is important to all of us, even though we are in that small minority of investors who can answer the six financial literacy questions correctly.

Above all, beware of overconfidence. Humility is a virtue.

Correct answers to 6 financial literacy questions

1. Suppose you have $ 100 in a savings account and the interest rate is 2% per annum. After 5 years, how much do you think you would have in your account if you let the money grow? Over $ 102

2. Imagine the interest rate on your savings account is 1% per year and inflation is 2% per year. After 1 year, how much could you buy with the money in this account? Less than today

3. Buying shares of a single company generally offers a more secure return than a mutual fund. False

4. If interest rates rise, what will generally happen to bond prices? they will fall

5. Suppose you owe $ 1,000 on a loan and the interest rate you are charged is 20% per annum, compounded annually. If you paid nothing at that interest rate, how many years would it take for the amount you owe to double? At least 2 years but less than 5 years

6. A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less. True

Mark Hulbert is a regular contributor to MarketWatch. His Evaluations of Hulbert tracks investment bulletins that pay a fixed fee to be audited. He can be contacted at [email protected].

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