37% More Net Wealth

Based on new research, an understanding of interest, inflation, and investment risk is associated with 37% higher net wealth than those at the same income level (wealth to income ratio) [1]. Annamaria Lusardi and Olivia S. Mitchell came up with three simple questions that have now proven to be a strong measure of financial literacy. These are known as the Big Three.  

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, compared to 48% of men. This, my friends, is what gets me out of bed in the morning! 

These 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. I suggest you challenge yourself by answering the questions first, before reading my commentary about the answers below them.

The “Big Three” Financial Literacy Questions

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

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

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

How did you do? If you nailed it, congratulations! If you aren’t sure, below is a review of each question along with a brief 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. That’s because $100 x 2% equals $102 so after five years it would be even more. The balance after the first year’s 2% interest would be $102. Adding another 2% each of the following four years would result in more than $102.

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 – Since this is a savings account earning interest and $2 would be earned the first year, the resulting figure for 5 years would have to be more than $102.

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 it 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 at all. 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. That’s right. 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 an 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 you would need to gain more on your savings (interest) than the increases in the cost of what you are purchasing (inflation). 

Exactly the same – To buy the same amount of goods in the future as you can today, your savings would need to increase (interest) as much as the increase in cost of goods (inflation). Since the interest you are gaining is 1% and inflation is 2% you will not be able to purchase the same amount as you 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 your return 100% dependent on the success of the one company whose stock you purchase. 

False – Buying a stock mutual fund is the equivalent of buying the stock of multiple companies (often more than 100). The risk of multiple companies’ stock losing money or going out of business altogether is less likely than one company. Less risk means it is safer. This is one of the reasons 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 you put the odds in your 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, you have a 50/50 chance of correctly guessing the answer if you are unsure. 

]1].        The wealth to income ratio findings can be found on page 10 of THE IMPORTANCE OF FINANCIAL LITERACY: OPENING A NEW FIELD by Annamaria Lusardi and Olivia S Mitchell for the National Bureau of Economic Research (April 2023).