The Jump$tart Coalition for Personal Financial Literacy recently released its national standards for personal finance education in grades K to 12. These standards describe the personal finance knowledge and skills that students should possess by, or before, high school graduation. A section of the standards relates to saving and investing. Below are key topics that investors of all ages need to know:
- Saving is a prerequisite to investing. It enables you to accumulate money that can be repositioned into higher-paying investment products (e.g., a growth stock fund averaging 8% versus a 2.5% passbook savings account). Having some savings earmarked for emergencies also means that you don’t have to withdraw invested funds to pay for expenses such as car or appliance repairs.
- The time value of money demonstrates the powerful effects of compound interest over time. Compound interest is the earning of interest on interest, as well as an invested amount (principal). The longer that money is invested, and the higher the average returns that are earned, the more wealth investors will accumulate. Even small differences in investment returns will make a difference when compounded over many decades of investing.
- Investors can use the Rule of 72 to estimate the time or interest rate needed to double an amount of money. For example, if you are earning a 6% average annual return, your money will double in 12 years (72 divided by 6). If you want to double your money in 10 years, you will need to earn an interest rate of 7.2% (72 divided by 10).
- An excellent long-term strategy for investing is to participate in a company retirement plan such as a 401(k), 403(b), or 457 plan. Benefits include the ability to write off the plan contribution from federal gross income, tax deferral of investment earnings, automatic withdrawal of plan contributions from workers’ paychecks, and, in many cases, employer matching of plan contributions. The latter is “free money” that should not be passed up, if at all possible.
- Dollar-cost averaging (DCA) is the investing of regular amounts at regular time intervals. An example is having $50 deducted monthly from your checking account to purchase mutual fund shares through an automatic investment plan. Another is having 5% of your pay deducted annually from bi-weekly paychecks at work. DCA takes the emotion out of investing because shares are purchased regardless of market conditions. When stock prices decline, investors can purchase more shares with their fixed deposit amount than when stock prices are higher.
- Stocks are an example of an “ownership” investment. Along with growth mutual funds, real estate, and collectibles, they provide investors with an opportunity to own something tangible and profit if the investment increases in value. Bonds and CDs, on the other hand, are examples of “loanership” investments. Investors deposit money with a corporation, government, or financial institution and earn periodic interest without any opportunity for long-term growth.
- Inflation and taxes can seriously erode investment returns. For this reason, investment experts recommend owning some stock or growth mutual funds to try to earn a higher return than inflation and taxes will eat away. For example, if you earn an 7% average return on a portfolio that contains stock, you’d have 5.25% after taxes in the 25% marginal tax bracket (7% - 7% x .25). If inflation averages 3%, you’d be ahead by 2.25%. On the other hand, if your savings and investments average only 3.5%, you’d have only 2.6% after taxes and a negative return after inflation.
- Investment products should be matched to financial goals. Short-term goals, such as college tuition needed within a year, should be kept in cash assets so that there is no variation in the value of principal. For long-term goals (e.g., retirement or college for a 3-year old), stocks and stock funds are appropriate.
