Financial Literacy: 5 Reasons You Should Have it
One of the major reasons I started this blog was because my friends asked for it. Many of them asked for it because they were entering, or finishing, law school and were faced with enormous debt loads and were coming to an age where they were becoming classier consumers. Trading in their futons and beanbag chairs for sofas and dining tables. While they sought practical applications for money, what they were really asking for was how to become more financially literate. An important topic for upcoming professionals that need to fund retirement 40 years down the road.
Financial literacy has been an avid passion of mine for many years. Advocating the benefits and small research costs involved is something I do for pleasure. It’s why I got the title of the money guy in my sphere of influence. Much to my chagrin though, financial literacy rates are still garbage in America. I was reminded of this fact while listening to NPR when they had a segment on the topic. While listening, all I could think about was a paper out of Wharton School of Business on the topic (you can read the overview of it here). This paper described the dire state of financial literacy in America and abroad.
Consequently, I thought a paper on the value of financial literacy might be in order.
The Research Cost of Financial Literacy
One of the major complaints people give about finance is “yuck, numbers.” I’m here to tell you that you can be financially literate and not get mired in data strings. In fact, while math has been used in economics since the 1700’s, it’s only recently become so math heavy. World War II and the advent of game theory economics is what spurred the heavy use of mathematical models and comparative statics. Remember, economics has been around since the dawn of civilization with the use of currency as a medium of exchange. However, while the history of economics is as old as ‘money’ itself, it wasn’t formally recorded until around 362 BCE with the writing of Oeconomicus – a completely non-math treatise by Xenophon about household management and agricultural principles.
I say all of that to tell you that you can be financially savvy and not a math whiz. You can understand how to manage your own portfolio with low cost index funds without knowing how to do differential equations. It’s easy to understand inflationary principles without understanding how to do the comparative statics on the value of money in an environment with and without inflation.
A solid understanding of interest rates, inflation, risk and diversification can save you thousands of dollars in interest fees and make you thousands of dollars through stock and bond portfolios. Fortunately, all of these topics can be mastered in just a few months with very little effort on your part!
The Value of Financial Literacy
It takes so little effort to understand principles of finance. Not to work without reward though, becoming literate has such an amazing payoff! Being financially literate lowers the cost of living. Here’s how:
- Lower lending costs: If you’ve read my article about having a good credit score, you should be familiar with this. Financially savvy people have good credit. That leads to lower interest rates for mortgages and auto loans. Those lower rates can lead to tens of thousands of dollar over the lifetime of a mortgage. That means more money in your pocket. Plus, somebody who understands interest rates would understand the profitability of refinancing for a more advantageous rate. As a Millennial, we’ve got our major formative money years in a low interest rate environment, but ask your parents. They will tell you the days about of hyperinflation in the 80’s and 5-7% interest in the 90’s.
- Lower fees for retirement: Do you use an Edwards Jones or some other money manager? Your financial downfalls are costing you a lot of dollar bills that should be earmarked for retirement. By not being competent enough to manage your own portfolio you’re giving up 2% of every trade you make to fees. You’re giving up 2% of every reinvestment or dividend. And You’re giving up an annual fee of some amount. That’s CRAZY. Now, I’m not advocating you open a brokerage account and buy and sell your own individual stocks, but you should be able to manage some basic index-based portfolios sold by entities like Vanguard or Fidelity. If you can do that, you can watch your yearly fees fall from $2,000 down to a few hundred bucks. Now compound those savings over 40 years.
- You will negotiate better: Ever walked into a car lot only to have them talk about financing plans and feeling lost? Now you don’t have to! Car lots are notorious places for their complicated sales. 0% APR for a year or $3,000 off the principal, which do you choose? Or they’ll set you up with a deal that’s 4% interest but you end up with 6% APR because they levy on huge finance charges that you don’t understand. With a little bit of knowledge, you can understand the terms better and thus be negotiating from a place a strength. No more getting hosed! However, if possible buy cars with cash. (Related: Why You Should Buy Cars with Cash)
- Actually use credit rewards: People with financial literacy have been shown to carry less debt and pay off their credit cards each month. By not carrying a balance, you can actually use those credit card rewards. I have a 2% cash back card, so I know all of my purchases over the entire year have a built in 2% discount. If I use approved vendors for purchases I need to make, I can bump that up to 5-10% depending on the rebate. So let’s say you spend $3,000 a month in expenses. That adds up to an extra $720 in your pocket or $28,800 after a 40-year career. That $28,800 is before any returns or interest too. So the amount would actually be higher! You can’t take advantage of these rewards when you carry a balance because your 17% or more interest rate is eating up the bonus earnings.
- Higher returns on investments: Investment products are more complicated than ever. No longer can you just buy a bond from the bank and call it a day. By understanding these products, you will feel comfortable investing in them and thus open up a whole new avenue of high return investments. Things like structured notes, peer to peer lending for personal and commercial uses, and bank created derivative products. I bet just seeing the word derivative conjured up feelings of fear from the 2008 crisis. A derivative is just a product whose outcome is tied to the performance of some other product (called the underlying security). They’re great ways to increase your returns, but reduce your risk. (Related: Book review about option spreads)
I hope you understand the value of financial literacy now. It’s a topic near and dear to me, but let me throw down some statistics found by that Wharton paper. The writers of the paper asked elementary questions about finance relating to inflation, interest rates, and risk. Of those with college degrees, only 44% answered all three questions correctly. Of those with just high school degrees, only 19% got all of them. Want some worse news?
Men tend to be more financially literate than women across the globe. 38.3% of men in America answered correctly compared to 22.5% of women. The actual rates varied across other countries, but men always did better. In America, where the divorce rate is ever growing (and Millennials are marrying less), women are being asked to be more financially independent. Women need to, at the very least, get on par; otherwise they risk being left behind. Overall though everyone needs to increase their financial literacy. Otherwise, you’re just leaving money on the table.
Readers can you answer these questions? 1. Suppose you have $100 and the bank is paying 2% a year. After five years, will you have $102, less than $102, or more than $102? 2. Imagine you earn 2% on your savings account and inflation is 3%. After one year, how much would you be able to buy with this account? More than today, less than today, or the same as today? 3. Is this question true or false: Buying a single company’s stock is safer return than a stock mutual fund. Let me know your answers in the comments!
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