Financial literacy means understanding how the financial decisions you make today can affect you in future, and starts with understanding basic financial principles that make up the backbone of financial planning.
The RAND Financial Literacy Center was established back in 2009 as part of an effort to create financial tools programs to assist individuals expand their understanding of personal finance. That effort also included developing a list of the most important financial literacy concepts for young consumers to understand.
If you don’t already know what some of these concepts are, here’s the list:
1. Seven to 10 Rule: I was unaware of this basic investment principle when I first came across it, but it’s basically a lesson in the idea of compounding interest. The rule describes how long it would take for an investment to double. While an investment made at a 7 percent rate of return would double in 10 years, one made at a 10 percent rate of return would double in just seven years. This basically means that if you invested $1,000 at a 10% rate of return it would then double to $2,000 in just seven years. In 14 years, that $2,000 would again double to $4,000 and so one.
2. Employee Matching 401(k): If you’re lucky enough to work for an organization that will match your 401(k) contributions then it’s definitely work taking advantage of. The amount an employer will can vary from company to company, but the real incentive behind these types of programs is that it’s a hassle-free way to earn free money towards your retirement.
In some instances, employers will match your own 401(k) contributions one to one, meaning that for every pre-tax dollar you contribute towards your own 401(k) plan your job will contribute the same amount.
A number of large companies dropped their 401(k) employee matching programs during the recession, though many are beginning to reinstate these programs and economic conditions improve.
3. Inflation: Inflation refers to the rise on the costs of everyday goods of a set period of time. The Bureau of Labor Statistics actually has a great inflation calculator tool on its website that allows you to see what a dollar during year would amount to in another. For example, an item that cost $3 in 1980 will now run you $8.23 in 2011. Between 2010 and 2011, the cost of goods rose by $0.04 on average.
Understanding inflation is vital to understanding how everyday costs can eat up your paycheck, especially if what you are earning isn’t rising with the costs of inflation. It’s also important to take into account inflation when planning for retirement, since the amount you may think you need to retire comfortably now could change drastically in five, 10 or 20 years.
4. Diversification: The idea of diversification basically means not putting all of your eggs in one basket in order to reduce your overall risk. This concept is a good rule of thumb for any number of life situations, but is especially useful when discussing investments.
For example, if you invested all of your money in the stock of one company then you risk losing it all in the event that company’s stock plummets. If, instead, you invest your cash in several different companies then you can reduce the likelihood of losing all of your money.
The Security and Exchange Commission suggests that consumers diversify investment portfolios at both between asset categories and within asset categories. This means that, in addition to diversifying investments between stocks, bonds and other types of assets, you should also diversify within each category. And remember, riskier investments generally offer higher returns, while less risky investments provide lower returns.
5. Tax-Advantage Accounts: Depending on how much you earn you’re responsible for paying a certain amount of income towards taxes. But, if you invest those funds in a retirement account such as an 401(k) then you can easily reduce your tax liabilities since funds allocated towards these type of accounts are pre-tax dollars. And, the more you contribute to these type of plans the less money you’re likely to owe the federal government in taxes.
Just remember, if you decide to withdraw funds from your 401(k) account before you’re 59 1/2 years old you’ll have to pay all the taxes withheld in addition to penalties.
What financial concepts do you think are important for young people to know? Let us know in the comments section.