Financial Planning

What's Your Financial IQ

How good are you at making financial decisions? The key to making sound choices, researchers say, is to understand three basic building blocks of finance: compounding, inflation and diversification.

"These concepts are essential, especially when saving for retirement," says Olivia S. Mitchell, director of the Boettner Center on Pensions and Retirement Research at the University of Pennsylvania's Wharton School. "But our research has shown that they are widely misunderstood."

Mitchell asks survey respondents three questions to gauge their financial savvy. See how you stack up.

Building Block No. 1: Compounding

Say you put $100 in a savings account with an annual interest rate of 2 percent. How much will you have in the account after five years?

A. More than $102

B. Exactly $102

C. Less than $102

D. Don't know

Answer: A. More than $102. The interest you earn each year can earn its own interest in future years. In this case you'd have $102 after year one, $104.04 after year two, and $110.41 after year five.

Compounding makes time your most important ally. Consider the following hypothetical investors:

The Early Starter

Saves $200 a month beginning at age 22

  • Total amount set aside in retirement plans: $103,200
  • Investment gains at a 7 percent1 annual return: $513,800
  • Total savings at 65: $617,000

The Mid-Career Starter

Saves $344 a month beginning at age 40

  • Total amount set aside in retirement plans: $103,200
  • Investment gains at a 7 percent1 annual return: $167,690
  • Total savings at 65: $270,890

The two investors save the same amount over their careers. But compounding helps the early starter earn far more investment gains -- so she's better prepared for retirement.

Building Block No. 2: Inflation

Say your savings account pays 1 percent per year and inflation is 2 percent. After one year, the money in the account will buy...

A. More than it does today

B. Exactly the same as it does today

C. Less than it does today

D. Don't know

Answer: C. Less than it does today. Inflation, the increase in the prices of goods and services, reduces the buying power of your money. If the inflation rate exceeds the return on your investments, your savings will be able to buy less over time.

To overcome rising prices, invest a portion of your long-term savings for growth. Stocks historically have provided the best chance to generate the growth needed to outpace inflation.

Building Block No. 3: Diversification

True or false: A single company's stock usually provides a safer return than a stock mutual fund.

A. True

B. False

C. Don't know

Answer: B. False. Putting all your money in one stock is a gamble: The value of your savings could drop dramatically if the company runs into problems. A stock mutual fund holds shares of many different companies, which reduces the risk that one company's troubles will significantly affect your finances.

Don't worry if you answered one or two questions incorrectly. In Mitchell's surveys only about 30 percent of Americans got all three questions right. Your financial advisor can help you better understand these and other financial topics and help you apply them to your retirement plan.

1 Hypothetical return and not representative of the performance of any investment.

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