Wednesday, November 16, 2016

Financial Knowledge Survey Results

Four weeks ago, I asked readers to take a financial quiz that I had to take on Amazon's Mechanical Turk. I was curious to see how other people scored.

The Results

The average Road To A Tesla reader taking the quiz got about 12 of 13 questions correct. For comparison, when I first took the quiz, I scored 13 of 13 correct. The person giving the original quiz on mTurk said the average score was 7 of 13 correct. Clearly, readers here have a better financial education than the typical person. That being said, there is still some room for improvement.

Correct answers are shown below in bold. Percentages after the answer show the percentage of responders who choose that option.

The Questions

Q: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, you would be able to buy:

  • More than today with the money in this account
  • Exactly the same as today with the money in this account
  • Less than today with the money in this account (100%)
  • Don't Know
Inflation measures how prices increases over time. Because prices are rising at the rate of 2% per year and you are only getting 1% per year, your purchasing power is decreasing by 1% per year. This means you will be able to buy less after 1 year than you could today.

Q: Do you think that the following statement is true of false?: "Bonds are normally riskier than stocks."

  • True (10%)
  • False (90%)
  • Don't Know

Bonds are promissory notes issued by companies. They are basically an IOU from the company to the bond purchaser that the company will pay you back the face value of the bond plus interest over a specified period of time. They are considered safer than stocks because they represent loans the company made and must pay back, whereas stocks are just shares of the company. Stock prices fluctuate based on how much other investors are willing to pay for the company at any given moment. Bonds, on the other hand, represent a well-defined, specific return.

Q: Considering a long time period (for example, 10 or 20 years), which asset described below normally gives the highest return?

  • Savings accounts
  • Stocks (90%)
  • Bonds
  • Don't Know (10%)

 The stock market has historically had the greatest return over a long time period.

Q: Normally, which asset described below displays the highest fluctuations over time?

  • Savings accounts
  • Stocks (75%)
  • Bonds
  • Don't know (25%)

As mentioned earlier, stock prices change based on how much investors think a company is worth at any given time. Because investors' sentiments can change both often and dramatically, stocks are the most volatile investment on a short term basis.

Q: When an investor spreads his money among different assets, does the risk of losing a lot of money:

  • Increase
  • Decrease (100%)
  • Stay the same
  • Don't know
Spreading money among different assets is called diversification and the purpose is to decrease the risk of losing money. The theory is that different assets won't move in the same directions at the same time. For example, if the stock market falls, the price of gold may rise. If an investor had put money into both stocks and gold, the loss in one area may be wholly or partially offset by gains in the other. You can also diversify within one asset class - splitting your money between transportation stocks and medical stocks, for instance.

Q: Do you think that the following statement is true or false?: "If you were to invest $1,000 in a stock mutual fund, it would be possible to have less than $1,000 when you withdraw your money."

  • True (80%)
  • False (20%)
  • Don't know

This is, once again, due to the volatility of the stock market. Although a mutual find invests in more than one stock, the whole fund is still made up of individual stocks that can change value by the minute or second. As a result, the overall value of the mutual fund can also change that often. However, given the large number of stocks held in a typical mutual fund, the average price of the fund is typically less volatile then any one individual stock, as winners and loses within the fund will tend to moderate each other. Nevertheless, it is possible for the share price of a mutual fund to decrease, leaving you with less money than you originally invested.

Q: Do you think the following statement is true or false?: "A stock mutual fund combines the money of many investors to buy a variety of stocks."

  • True (90%)
  • False
  • Don't know (10%)

The definition of a mutual fund is a pool of money from multiple investors used to buy stocks of various companies. Sometimes the stocks the fund buys are limited to specific industries, such as healthcare, or to stocks making up certain indexes, such as the S&P 500. Others times there is no such restriction.

Q: Do you think that the following statement is true or false: "After age 70 1/2, you have to withdraw at least some money from your 401(k) plan or IRA."

  • True (75%)
  • False (12.5%)
  • Don't know (12.5%)
The government has rules that require you to start withdrawing money from tax deferred accounts such as 401(k)s and IRAs. In same cases you can start withdrawing money earlier, but as a rule, you must start withdrawing some money when you reach 70 1/2 years old.

Q: Do you think the following statement is true or false?: "A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less."

  • True (100%)
  • False
  • Don't know
A shorter term loan will result in less overall interest paid because you are borrowing money for a shorter amount of time. However, due to the shorter payback period, the amount of your payment that has to go towards repaying your principal (the amount you borrowed) will be higher. This results in higher total monthly payment, even though you are paying less interest. An amortization table for the loan tells you how much of each payment goes to interest and how much goes towards principal reduction.

Q: Suppose you have $100 in a savings account and the interest rate is 20% per year and you never withdraw money or interest payments. After 5 years, how much would you have in the account in total?

  • More than $200 (100%)
  • Exactly $200
  • Less than $200
  • Don't know
Because you never withdraw any money, your interest is compounded. That is, you get paid interest on interest you have already earned. In this example, after one year, you would earn $20 in interest on $100 of principal. In the second year, you would earn $24 on $120 of principal. Next next year, you would earn interest on $142 of principal, etc. As a result of this compound interest, after 5 years, you will earn more than just five times 20% of your initial savings.

Q: Which of the following statements is correct?

  • Once one invests in a mutual fund, one cannot withdraw the money in the first year
  • Mutual funds can invest in several assets, for example invest in both stocks and bonds (50%)
  • Mutual funds pay a guaranteed rate of return which depends on their past performance
  • None of the above (37.5%)
  • Don't know (12.5%)
The second statement is the only one that is correct. Some funds may charge a penalty fee if you withdraw money within a certain time period after the initial purchase, but you are always free to withdraw your money at any time. No mutual funds pay a guaranteed rate of return - if that is what you are looking for, you want a savings account or certificate of deposit (CD). And, as you always hear about the stock market, past performance is no guaranty of future results.

Q: Which of the following statements is correct? If somebody buys a bond of firm B:

  • He owns a part of firm B
  • He has lent money to firm B (100%)
  • He is liable for firm B's debts
  • None of the above
  • Don't know

Bonds are promissory notes to companies. The bond buyer is making a loan to the company. If you want to own part of the company, buy the company's stock.

Q: Suppose you owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an annual percentage rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?

  • Less than 5 years
  • Between 5 and 10 years (12.5%)
  • Between 10 and 15 years (12.5%)
  • Never (50%)
  • Don't know (12.5%)

Payments to credit cards are always first applied to accrued interest, then to any outstanding principal. Paying $30 per month on a $3,000 balance is paying 1% per month. Because that is the same amount of interest you are being charged each month, your entire payment goes towards paying the interest and nothing goes towards reducing your outstanding balance. As a result, you will never pay off your credit card. Typically, most credit cards set the minimum payment amount so that it includes at least 1% principal reduction, so the situation is usually never as bad as this scenario. However, it's not a whole lot better either.

How did you do on these questions?


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