What does ‘financial literacy even mean?

Financial literacy is the ability to make informed judgements and to take effective decisions regarding the use and management of your own money.

Financial literacy can involve many aspects – financial planning, understanding your ‘balance sheet’ (Assets, Liabilities and Equity) and cash flow, properly managing debts, and understanding interest and the time value of money.

More simply put, the key principles of financial literacy include:

• Creating budgets and budgeting
• Being able to track your expenditure
• Effectively and efficiently paying off your debts
• Properly planning for the future (e.g. key milestones or retirement)

Studies have indicated that improved levels of financial literacy can lead to positive behaviour change:

• Individuals are better able to manage money
• More likely to participate in investing (e.g. sharemarket) with their portfolios performing better
• More likely to accumulate larger amounts of wealth
• Better debt management – less costly mortgages, avoidance of high interest payments such as credit card interest

There are five key indicative behaviours of financial literacy:

1. Keeping track of finances: approaches to managing everyday expenses
2. Planning ahead: planning for the medium and longer term, including retirement and beyond.
3. Choosing financial products: undertaking research, understanding and assessment investment risk.
4. Staying informed: use of information, tools and guidance when needed.
5. Financial control: savings behaviour and managing debts.

In an ideal world, everyone should be financially literate. Unfortunately financial illiteracy affects all ages and socio-economic levels, regardless of where you are from and how you were brought up. The nasty side of financial illiteracy is obvious – poor financial decisions which may include owing large amounts of debt at an astronomically high interest rate. This situation is quite relatable and is fairly common in households all around the world.

In 2018, over 17,000 Australians were asked questions testing financial literacy as part of the Household, Income and Labour Dynamics (HILDA) survey. 

• Only about 50% of those surveyed appeared to have a good grasp of the basic concepts (i.e. answering all five questions correctly) – yep, that suggests 50% of Australians have some degree of financially illiteracy. That’s a scary proportion given how important money is in everyone’s lives.
• The survey also suggests that proportionally, more men are financially literate compared to women.
• Older people are generally more financially literate than younger generations.

In fact, the five questions are are below – can you answer all five correctly?

1. Suppose you put $100 into a no-fee savings account with a guaranteed interest rate of 2% per year. You don’t make any further payments into this account, and you don’t withdraw any money. How much would be in the account at the end of the first year, once the interest payment is made.

2. Imagine now that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, would you be able to buy more than today, exactly the same as today, or less than today with the money in this account? (More, exactly the same or less?)

3. Do you think that the following statement is true or false? “Buying shares in a single company usually provides a safer return than buying shares in a number of different companies.” (True or false?)

4. Again, please tell me whether you think the following statement is true or false: “An investment with a high return is likely to be high risk.” (True or false?)

5. Suppose that by the year 2020 your income has doubled, but the prices of all of the things you buy have also doubled. In 2020, will you be able to buy more than today, exactly the same as today, or less than today with your income? (More, exactly the same or less?)

Through my various blog posts, I aim to cover most of the above, with an emphasis on financial control, keeping track of finances and planning ahead. I don’t plan on talking much about financial products in any great detail, I am sure there are other websites that can better inform you on those. Additionally, I’ll introduce some simple but valuable mathematical concepts such as compound interest, the time value of money and diversification (in the investment context). By the time you get through all these, those five questions above will be a piece of cake!

I hope this helps frame your thinking for some of the future posts coming up!

– AussiePersonalFinance