As you bounce around the Internet, reading various news stories related to finance, business, or the economy, you are likely to come across the phrase financial literacy. Perhaps not surprisingly, attention to the concept and use of the term seems to have increased following the 2008 financial crisis and the resultant impact on individuals and decimation of families.
Not only have the news stories about the topic increased, in the year that ended yesterday, numerous states enacted legislation or adopted resolutions with regards to teaching financial literacy in our schools. No doubt that attention to the concept and definitive actions by state legislatures is a good thing.
With that as our back drop, and as we head into 2014, there are three questions for SavvyReaders to consider. First, what exactly does it mean to be financially literate? Second, what are some key concepts to master to attain financial literacy – particularly with regards to retirement planning? Third, how exactly does being financially literate benefit you and your family?
Dictionary.com offers these definitions of financial and literate respectively:
fi•nan•cial [fi-nan-shuhl, fahy-] adjective. Pertaining to monetary receipts and expenditures; pertaining or relating to money matters.
lit•er•ate [lit-er-it] adjective. Having knowledge or skill in a specified field.
Taken together, I believe we can answer the first question by stating that financial literacy means that an individual possesses knowledge and understanding of matters pertaining to money matters.
With regards to the second question, there are numerous concepts that should be understood; however, I want to focus on the five that I believe are most critical: compound interest, investment options, fees, emergency funds, and withdrawal plans.
Compound Interest: While simple Interest is calculated one time, solely as a percentage of the principal sum, compound interest is calculated not only on the initial principal but also the accumulated interest of prior periods. It is discussed in detail here, here, and here.
Investment Options: An investment is an item (asset) that is purchased with the hope that it will appreciate in value, generally with the purpose of generating future income. Common investment options to know and understand include equities (stocks), bonds, mutual funds, exchange traded funds (EFT), life-cycle funds and index funds.
Fees: As might be suspected, it is impossible to avoid fees entirely, in one of their various forms (e.g. management, adviser, trading, loads, etc.), when choosing any of the above investment options. Therefore, an essential key to successful investing is to keep them to a minimum. The value of minimizing fees is discussed here and in one of our SavvyRecommendations, The Retirement Gamble.
Emergency Funds: This is a cash account that is used only in the event of an emergency, to fill critical financial gaps, or meet unexpected expenses. It is immediate access to cash that allows you to take care of unforeseen circumstances without impacting the money you have committed to saving and investing. Its importance is discussed in detail here.
Withdrawal Plans: While many people focus on building a fiscal foundation during their 20s and 30s; and accumulating wealth as they enter their 40s, they often do not adequately consider the third stage of retirement planning which includes developing a practical withdrawal plan. Doing so will ensure that you will not run out of money halfway through retirement. Developing your withdrawal plan is discussed here.
Next week we’ll consider the third question, “how exactly does being financially literate benefit you and your family?”