By: Laura Walton AFC®
It seems we are trending in that direction. Financial understanding is falling while our confidence in making financial decisions is rising – perhaps the worst of both worlds. We’re making poor decisions but with confidence! See how you score on this 6 question quiz.
Arizonans averaged 3.25 correct answers out of the 6 questions, better than the national average of 3.16 correct answers. Try your hand at the quiz.
The New York Times reported on FINRA’s study, Financial Capability in the United States 2016, an online survey of 25,000 individuals.
Five of the questions have been asked over the years in prior studies allowing us to see trends:
Percentage of people getting 4 of the 5 standard questions correct
Percentage of people who gave themselves a “very high” rating on financial knowledge
Only 28% got the answer to this question right: What happens to bond prices when interest rates rise?
The answer? Bond prices go down; bond prices and interest rates have an inverse, teeter-totter relationship.
Bonds aren’t well understood, the topic of Jason Zweig’s article in the July 16-17 weekend edition of the Wall Street Journal. With returns on bonds at historic lows and the prospect of rising interest rates, the conventional wisdom is to avoid bonds. He thinks otherwise and makes these points:
1) It’s not what you earn but rather how much you keep. For example, a 10-year Treasury Bond earning 1.5% doesn’t sound like much but when compared to 1% inflation, the net positive is .5%. Quick lesson: 1.5% is the “nominal” yield (translation “in name only”) while .5% is the “real” yield once adjusted for inflation.
He cites a survey which asked individuals if they’d prefer to get a 2% raise when inflation was 0% or a 5% raise when inflation was 4%. Two-thirds preferred the 5% raise. Wrong answer. 5% sounds better but the “real” raise is less (1% versus 2%).
Our tendency to focus on the nominal yield without taking into account inflation, or other costs for that matter, can lead us to poor financial decisions.
2) High quality bonds provide an important balance in our portfolios. Risk and reward go hand in hand. Stocks tend to have higher risk along with higher returns while bonds are considered lower risk and, therefore, produce lower returns. Because of this, those nearing retirement tend to have a higher allocation of bonds than when they were younger because they become more risk averse.
Conclusion: (1) Look beyond the nominal rate. What is your real return? (2) does your stock/bond allocation reflect your risk tolerance, and (3) know that you may be more confident than knowledgeable – ask questions of a professional that you trust, i.e. a fiduciary.
Next week, things that Vanguard founder Jack Bogle says investors do “that makes no sense, none, nada, nil,”.…probably because we think we’re smarter than we are!