top of page

Greater Wealth with the Same Income

Updated: Apr 29

Research by Annamaria Lusardi and Olivia S Mitchell for the National Bureau of Economic Research, shows the ability to understand interest, inflation, and investment risk (known as The Big Three) is associated with more net wealth among those at the same income level.  


“If a respondent were to answer all of the Big Three correctly, this is associated with 45% more net wealth, 82% more financial wealth, and 16% more non-financial wealth, at the median.” 


Sadly, only 43% of U.S. respondents are able to correctly answer the Big Three Financial Literacy Questions. If that fact wasn’t startling enough, only 29% of women answer all three correctly. This my friends, is what gets me out of bed each morning! 


These basic financial literacy questions from Lusardi and Mitchell are a great way to test your own knowledge or start a conversation with someone whose financial literacy you want to encourage. 


Let’s dig into the Big Three Financial Literacy Questions. Note your answer before moving on to read my commentary on each possible answer. 


Question 1 is about how interest is applied to savings.


1) 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

  • Less than $102

  • Do not know/Refuse to answer

These questions are designed to test your understanding of the topic. They require knowledge of terms like interest rate and savings account. The correct answer is in bold.


More than $102 – This first option is correct. If $100 is left in an account earning 2% a year for five years, it would have More than $102.  That’s because $100 x 2% equals $102 so after five years it would be even more. 


Exactly $102 – If the question asked how much the account would have if left for one year, this would be the correct answer. Since it is asking how much it would be if left for five years, we know it would be more than $102. 


Less than $102 – This answer is incorrect for two reasons. First, the 2% interest applies for five years; $102 reflects only one year of interest. Second, for the amount to be less than $102 would require some other factor that would reduce the amount. 


Do not know/Refuse to answer – This answer is incorrect for many reasons. First, it doesn’t answer the question. Which guarantees you don’t get credit. Second, a random guess between 1 and 3 would give you a 1 in 3 (33%) chance of correctly answering it. Even if you don’t know or aren’t 100% sure, you are better off guessing than selecting, Do not know/Refuse to answer. Being unsure or not knowing the answer is okay. Not attempting by taking a guess is not okay. I say this because it is a habit I had to kick. Even when the odds were in my favor, too often I would select Do not know if I wasn’t 100% confident in my answer. That is, until my husband pointed out that playing it safe wasn’t actually safe. The fear of answering incorrectly is most common among women. Which Lusardi and Mitchell point out is a lack of confidence, not a lack of knowledge. Yep, part of the financial literacy gap is actually a confidence gap.  


While it’s not needed to answer the question, let’s walk through the full question for the sake of deeper understanding. If you put $100 into a savings account that earned 2% a year for five years, it would grow to be $110.41. 


Year 1 - $100 x 1.02 = $102.00

Year 2 - $102 x 1.02 = $104.04

Year 3 - $104 x 1.02 = $106.12

Year 4 - $106 x 1.02 = $108.24

Year 5 - $108 x 1.02 = $110.41


This is a small example of how compound interest works. Meaning, when you leave both the principal ($100), plus the interest ($2) in to continue to accumulate, the interest compounds because it is being applied to both the principal and the interest. 


Question 2 is a bit harder because it requires an understanding of interest and inflation.


2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?

  • More than today

  • Exactly the same

  • Less than today

  • Do not know/Refuse to answer

To answer this question, we need to compare the impact of the interest to the impact of inflation. Inflation means the cost of goods (food, fuel, etc.) are increasing.  In this case, the value of our savings increases by 1% (interest) and the cost of goods increases by 2% (inflation).

More than today – In order to buy more a year from now we would need to gain more on our savings (interest) than the increases in the cost of what we are purchasing (inflation). 


Exactly the same – To buy the same amount of goods in the future as we can today, our savings would need to increase (interest) as much as the increase in cost of goods (inflation). Since the interest we are gaining is 1% and inflation is 2% we will not be able to purchase the same amount as we can today. 


Less than today – Since prices are growing by 2% and our savings is only growing by 1%, this is true. Our money isn’t growing as much as prices, so we can’t buy as many goods in the future. 


Do not know/Refuse to answer – The problem with selecting Do not know/Refuse to answer is you are knowingly getting it wrong. Even if you aren’t 100% sure what the correct answer is, selecting what you think it is or even taking a guess is more likely to result in a better score than refusing to answer. 


Question 3 is focused on investment risk.


Since it is asking about the risk associated with buying stock, we don’t need to know any specifics about the stock other than the risk of purchasing a single stock versus the risk of purchasing a stock mutual fund. The key to this question is understanding a stock mutual fund is a bundle of stocks from multiple companies. It doesn’t mention the term directly, but the core of this question is about diversification. 


3) Please tell me whether this statement is true or false. “Buying a single company’s stock usually provides a safer return than a stock mutual fund.” 

  • True

  • False

  • Do not know/Refuse to answer


True – Since buying stock is risky and there is no way to know what the future price will be, purchasing only one company’s stock makes our return 100% dependent on the success of the one company whose stock we purchase. 


False – Buying a stock mutual fund is the equivalent of buying the stock of multiple companies (often more than 100). It is safer than buying the stock of one company. The risk of multiple companies’ stock losing money or going out of business altogether is less likely than one company. This is one of the reasons why mutual funds are so popular.


Do not know/Refuse to answer – If you’ve gone through the prior two questions, you already know, I dislike this option. I would rather put the odds in my favor by guessing at one of the answers than to not answer it at all by selecting Do not know/Refuse to answer. Since there are only two actual answers to select from, I have a 50/50 chance of correctly guessing the answer if I’m unsure. 


Answers to the “Big Three” Financial Literacy Questions

  1. More than $102,

  2. Less than today,

  3. False

6 views0 comments

Recent Posts

See All

Comments


bottom of page