Occasionally a survey has questions to assess financial knowledge. They seem straightforward to me, and I took for granted knowing the answers. One survey reported the average respondent gets only 55% correct. These seem like things all people should know so I took the liberty to explain the answers to common questions, not so you can pass a test but to benefit you in your personal finances.
(1) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy:
Suppose today you have $100 and you want to buy a pair of $100 shoes. Instead you save the money.
In 1 year:
-You will have $101
Interest on your savings=1% $100 + ($100 * 0.01) = $100+$1=$101
-Shoes will cost $102.
Inflation=2% $100 + ($100 * 0.02) =$100+$2=$102
(2) Do you think that the following statement is true or false?
“Bonds are normally riskier than stocks.”
Companies can borrow money by selling Bonds. Selling bonds is like taking out a loan. The bond is setup with an interest rate and a “term” (term is like the life of a loan, when the money is due). If you buy a bond, you know the rate and the term of the loan. Say it is a 3% bond with a 1 year term, if you buy $100 worth of that bond then in 1 year the company will pay you back $103 and at that point the whole matter is settled. That means there is a whole lot of certainty with bonds. The only uncertainty is the chance that the issuer of the bond defaults, for instance they go bankrupt. If that happens, you are likely to get some money back. You are a creditor and bankruptcy court sell off all the assets of the company and distribute proceeds to creditors. Your $100 bond may only get you $25, but losing $75 is better than losing $100.
Alternatively, when you buy stock in a company you become a partial owner of the company. There is no “term” or interest rate. Your stock is worth what someone is willing to pay you for it. If the company starts performing worse, the value of your stock goes down. If the company goes bankrupt, then you own a bankrupt company , i.e. your stock is worth $0.
(3) Considering a long time period (for example, 10 or 20 years), which asset described below normally gives the highest return?
A savings account pays a very, very low interest rate. With savings, you are basically loaning that money to the bank so that they can loan it to other people for things like car loans or mortgages. They have to pay you a lower rate than the people with loans pay them. Savings pays the least.
Bonds pay more than savings because a bond is more like a car loan or mortgage. A company or government is borrowing money and they are paying the going rate for that “loan”.
A company takes a loan (i.e. sells bonds) in order to grow the business. It only makes sense to pay for a loan if you can grow the business by more than the cost of the loan. As a stockholder, you own the business. So in the long run, the owners are growing the business at a higher rate than the “cost of money” (i.e. bonds).
(4) Normally, which asset described below displays the highest fluctuations over time?
Savings accounts have a fixed interest rate. They will grow very steadily.
Bonds also have a fixed interest rate defined in the contract associate with the bond. They have some volatility though because people resell bonds. If I bought a 20 year bond at an interest rate of 10% but 5 years later I need my money, I can sell that bond to you. However, what if the going rate for newly issued bonds is no longer 10%? The going rate determines how interested you are in buying my bond. If the current rate is 15% then you don’t want to buy my bond, you want to buy a new bond. If the going rate is 5%, then you want to buy my bond because it is better than anything new being sold. This creates volatility in the value of bonds.
Stocks are volatile for different reasons. Remember, a stock is only worth what someone else is willing to pay you for it. What I will pay for a stock depends upon what I THINK it will be worth in the future. What I think it will be worth depends upon 2 things: the performance of the company AND the economy as a whole. There is a lot of uncertainty and emotion. Stocks can go on wild swings even when the day to day operations of the company don’t change at all.
(5) When an investor spreads his money among different assets, does the risk of losing a lot of money increase or decrease?
If I buy $100,000 stock in company A then if that company goes bankrupt I have $0. Instead, I buy $20,000 each in companies A,B,C,D & E. Now if company A goes bankrupt, I have only lost $20,000.
(6) Do you think that the following statement is true or false?
“If you were to invest $1,000 in a stock mutual fund, it would be possible to have less than $1,000 when you withdraw your money.”
A stock mutual fund simply owns a bunch of stocks. Stocks can go up and down in value and if they go down, the fund goes down.
(7) Do you think that the following statement is true or false?
“A stock mutual fund combines the money of many investors to buy a variety of stocks.”
That’s just what a mutual fund does. Let’s say that you want to diversify your money by purchasing shares in the 500 largest companies. Each one of those companies sells shares of stock and the cost of 1 share will vary. Company A may cost $10 per share but company B may cost $250. (A big factor in the cost per share is how many shares there are in total. Say 2 companies are identical but one issues 1 million shares and the other issues 2 million shares. Shares in the 2nd company are worth ½ as much because you own a smaller piece of the company.) Back to the mutual fund, imagine that the average share price is $100. To own 1 share in each of the 500 companies you would need 500*$100=$50,000. You don’t have that much, so you pool your money with other investors and together you have enough to diversify. That’s what a mutual fund does, pools your money with other investors and uses it to buy lots of stuff.
(8) Do you think that the following statement is true or false?
“After age 70 1/2, you have to withdraw at least some money from your 401(k) plan or IRA.”
By law, you are required to start withdrawing money from IRAs (Individual Retirement Accounts) at age 70 ½ . This is designed to keep wealthy people from taking advantage of the tax benefits of IRAs to simply grow their wealth and pass it on via inheritances. It is trying to force you to use IRAs for their designed purpose, retirement income.
(9) Do you think that the following statement is true or false?
“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.”
15 Yr Loan 30 Yr Loan Loan Amount $100,000 $100,000 Interest Rate 4% 4% Payment $740 $477 Payments 180 360 Total Paid $133,200 $171,720 Total Interest Paid $33,200 $71,720
(10) Suppose you have $100 in a savings account and the interest rate is 20% per year and you never withdraw money or interest payments. After 5 years, how much would you have in this account in total?
This illustrates the importance of Compound Interest:
15 Year Loan 30 Year Loan Year Balance Year's Interest 1 $100 $20.0 2 $120.0 $24.0 3 $144.0 $28.8 4 $172.8 $34.6 5 $207.4 $41.5 End $248.8
(11) Which of the following statements is correct?
Once one invests in a mutual fund, one cannot withdraw the money in the first year. you can buy and sell mutual funds daily just like trading stocks.
Mutual funds can invest in several assets, for example invest in both stocks and bonds. there are all sorts of mutual funds with mixes of stocks and bonds.
Mutual funds pay a guaranteed rate of return which depends on their past performance A mutual fund goes up and down, just like the stocks/bonds that it owns.
(12) Which of the following statements is correct? If somebody buys a bond of firm B:
A bond is a loan. Companies sell bonds to raise money for some purpose, with a contract to pay back the value of the bond plus interest.
(13) Suppose you owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an annual percentage rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?
1% of $3,000=$30. Thus, the interest on your $3,000 debt is $30 per month. If you pay $30 per month then you are paying the interest only and not paying anything to reduce the outstanding balance. The balance will remain at $3,000 forever