Recently, CNBC posted this article suggesting that 70% of Americans could not answer the following financial questions:

1. Do you think that the following statement is true or false? Buying a single company stock usually provides a safer return than a stock mutual fund.
2. Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow: More than $102, exactly $102, or less than $102?
3. 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 more than, exactly the same as, or less than today with the money in this account?

While these questions may seem intimidating to some, the concepts they are trying to touch on are actually quite simple.  Let’s run through these three questions with the appropriate answers, and discuss the topics they are trying to discuss:

Do you think that the following statement is true or false?  Buying a single company stock usually provides a safer return than a stock mutual fund?

Answer:  False.  This question is testing the readers knowledge of diversification and its role in the investment process.  Put simply, this question is answered by the old saying “don’t put all of your eggs in one basket”.  In the most basic form, a share of stock represents ownership of a company (let’s use Nikola for this example, or NKLA as the ticker).  Buying a share of CMG could have proven to be a very wise investment, had you rode the wave from $10 / share to $65 / share.  If you were so lucky as to time it perfectly, you could have more than 6x’ed your money!  This is the case for why it can be beneficial to invest in individual companies if you are able to smartly pick a winner.  However, like me, most of us aren’t that smart.  If you had bought into NKLA at the peak of $65 around June 2020, you would now be holding a stock worth $13 as of April, 2021.  This example demonstrates the increased risk of owning individual stocks, which is variance.  While you can certainly make more money by picking a winner, you can also lose more by having bad timing or picking a loser.  In order to reduce variance, most people (and myself) would encourage diversification by purchasing a “basket” of stocks.  Using historical data, a broad basket of stocks will provide you with positive returns of ~10% per year (S&P 500).  Using this method, you will not be tripling your money in a year, but you are also much less likely to see your portfolio drop by 50% in a similar time period.  This is the benefit of diversification.

Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow: More than $102, exactly $102, or less than $102?

Answer: More than $102. This is essentially a simple math question, but the context is to introduce the concept of compounding interest.  From a mathematical standpoint, if you put $100 in a savings account that generated 2% interest per year, you would have $102.00 at the end of the first year ($100.00 * 1.02 = $102.00).  After the second year you would have $104.04 ($102.00 * 1.02 = $104.04), after three years $106.12, after four years $108.24 and after five years $110.40.  Why does this occur?  Well, since you are earning the same rate of interest each year, after the first year you are not only earning 2% on that original $100 but you are also earning 2% on the $2.00 you made in interest in the first year.  As you can see, the longer you let your money compound, the faster it grows.  This is the best argument for investing and saving as much as possible as early as possible.  The longer you have to let your money grow, and to earn money on the money that you’ve already earned, the larger your savings / investments will snowball into larger and larger balances.

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 more than, exactly the same as, or less than today with the money in this account?

Answer: Less.  This lesson is about inflation’s impact on purchasing power.  Inflation occurs as the cost of goods rise over time due to an increasing amount of money “in the system”.  There are various reasons for inflation to occur at different rates, but these are not in the scope of today’s conversation.  Again, let’s break this down to a simple mathematical example.  Assume that you can buy a Widget for $1.00 and that you have $100.  That means that you could go out and buy 100 Widgets today.  Now, let’s fast forward a year.  In one year, you will have $101 ($100.00 * 1.01) while the cost of a widget will be $1.02 ($1.00 * 1.02).  Can you still by 100 Widgets after one year?  Unfortunately not, you can only by 99 widgets one year from now ($101 / $1.02 = 99.02).  When inflation (2%) is higher than your interest on savings (1%), you will effectively “lose” money each year as a result of your purchasing power being diminished.  This fact is a large reason why keeping most of your money in the bank (as opposed to invested in stocks or bonds) is not always the best idea.  While you may be earning 1% per year in a very safe manor, you are effectively losing money since the cost of goods is rising at an even faster rate.

In future posts I’ll dive into these topics on a deeper level, and provide some insight on how the implications of these lessons impact decision making when it comes to what to do with your hard earned money.  Thanks for reading, and feel free to e-mail me with any questions!