The Importance of Financial Literacy

The Importance of Financial Literacy

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“Money comes and goes, but if you have the education about how money works, you gain power over it and can begin building wealth. Illiteracy, both in words and numbers, is the foundation of financial struggle.”

Robert Kiyosaki

It’s no secret Americans fall short when it comes to financial literacy. In fact, only 57% of the U.S. adult population is financially literate, which is only slightly higher than that of Botswana, whose economy is 1,127% smaller. Financial illiteracy affects every part of society. The irony lies within us — although the US is regarded as a financial superpower, the very own citizens in America are ignorant when it comes to managing or planning for their prospective finances.

Financial illiteracy is a global problem, but it is even a more pervasive problem in the United States than most would expect from such a highly developed nation. Individuals about to enter into the workforce or retire have an inadequate amount of financial knowledge. That obstructs them from intelligent personal finance planning, and, ultimately, financial stability. But, everyone who finds financial success usually has the same advice: it’s not about how much money you make, it’s about what you do with it.

The Disadvantages of Time

The simple approach of making money and then saving it will not be beneficial for you in the long run. This is all because of one thing: inflation.

Inflation is the rate at which the general level of prices for goods and services is rising. Consequently, the purchasing power, or the amount of goods and services you can buy with one unit of your currency (i.e. $1), falls. For example, if you have $100, that can buy you 20 $5 bags of candy. If each bag of candy doubles in price to $10, now you can only buy 10, which means your purchasing power has fallen in half. Every person’s goal is to grow their money in a way that preserves or increases their purchasing power. In other words, people want to beat inflation when saving and growing their money.

The drawback of saving is that returns are often inferior compared to the returns of investing. Because these returns are lower, you are prone to losing purchasing power over time. Every year spent saving money is another year inflation devalues that money. However: savings are the bedrock of any competent financial plan. While savings may not offer high returns, they offer safe returns, hence why the returns are lower. They provide safety in case events materialize that drive down investments in places like the stock market, such as a global health crisis. Before investing all of your money into risky stocks, make sure you are not broke or are not in a mountain of debt. Set goals, know how much safety you want with your money, plan your life, and then work towards an accountant and financial planner. Once you get the foundation down, you’re ready for the next step.

The Advantages of Time

The most beautiful thing that we have is the gift of time. You can take advantage of time by utilizing it to make money work for you.

Photo by Wealthsimple

The thing about investments is that many people tend to stray away from the topic because it sounds perplexing, but the truth is that you don’t need to be Warren Buffett to understand it. As I’ll later explain in the article, investing is risky, but the returns it can offer can grow your money and help you achieve financial stability.

Assets vs Liabilities

“The rich focus on their asset columns while everyone else focuses on their income statements.”

Robert Kiyosaki

However, investing is simply not enough for your benefit. When it comes to financial literacy, the single most important thing to understand first is how to distinguish assets, what you own, and liabilities, what you owe. In short, assets provide money whereas liabilities eat away money. Once you understand the difference between assets and liabilities, the goal is to own assets and not have any liabilities. Whether you’re a person or a company, understanding this is crucial, as too many liabilities ultimately destroy your chances of financial success.

Risk and Diversification

No discussion of financial literacy would be complete without discussing risk. Risk is ever-present in our daily lives, not just in financial markets. Risk is what drives people to save as well as invest in stocks and other investments. The best way to deal with risk is through diversification. Diversification reduces risk by making investments in things that span different financial instruments, industries, and other categories. In other words, diversification is not putting all your eggs in one basket. By finding a balance in a diversified portfolio, you are lowering that risk at the cost of the reward. Sure, you can put all your money into one stock, hoping it will grow. If it doubles, then good for you! But, if it falls in half, then you’ve lost half your savings.

According to behavioral scientists, losses hurt more than proportionate gains, a principle known as loss aversion. For example, if you made $100, you would feel like you made $100. But if you lost $100, you would feel like you had lost more than $100. This means that people tend to preserve what they have rather than take a huge risk. This is a huge part of what leads people to manage risk and diversify.

As a result, Try to find that balance of assets in your portfolio that will benefit you the most. Maybe you want the majority of your money in a savings account, or maybe you want to have the majority in stocks. Maybe you want to throw in a few bonds as well. The solution is different for everybody as it all depends on your financial situation and age.

Getting Started with Investing

A great way to start investing is by investing in an index fund, which is a passive strategy. An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of an index, which is a group of different stocks, bonds, or any type of investment. Over time, the Standard & Poor’s 500 stock index (S&P 500), has returned about 10 percent annually, but it may fluctuate greatly in any year. I personally use the Schwab S&P 500 Index Fund. You’re basically buying part of the 500 largest stocks listed on American exchanges. This is a strategy that has worked for many people who can’t keep up to date in on every development in the stock market but who know that the market tends to trend upwards in the long run. Even Warren Buffett recommends non-professional investors invest in index funds.

“A low-cost index fund is the most sensible equity investment for the great majority of investors.”

Warren Buffett
Photo by Seeking Alpha

Final Thoughts

Unfortunately when it comes to investing, it isn’t that easy to earn high returns. This is why, again, financial literacy is important. In order to make intelligent financial decisions, whether it’s choosing to invest in a certain stock, choosing which bank to save with, or sorting through different options for a loan, one must have an understanding of how money works.

As of now, we are in the midst of a recession caused by the coronavirus. Negative oil prices, higher inflation, low interest rates, and even negative-yielding bonds all indicate it. However, now, as you’re staying at home, it’s the best time to learn how to be financially literate and make your first investments. The stock market has fallen quite a bit and now stocks seem historically available cheaper, which may be an opportunity to buy. But don’t take my word for it. Rather, learn how to invest in yourself and your knowledge. It’s an investment that I promise will pay off hugely.

About the author

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I write about finance, social issues, entrepreneurship, and technology. I am a high school senior from the Bay Area.