Financial Literacy (AKA How Not to Be Your Own Worst Enemy When It Comes to Saving, Investing, and Planning)

What Does it Mean to be Financially Literate?

In the simplest sense, financial literacy means understanding the topic of money and your personal finances. Financial literacy has two key layers. First, it is the confident understanding of concepts including budgeting, saving, investing and debt that leads to an overall sense of financial well-being and self-trust. Secondly, it is the ability to gain greater understanding of your finances so you can be the hero of your own financial narrative.

It can also have a significant impact on your future financial outcomes, including being financially secure in retirement. According to a recent survey (2020 The Stability and Predictive Power of Financial Literacy: Evidence from Longitudinal Data) it helped provide:

  • 2.5% increase in financial satisfaction
  • 6% increase in retirement planning
  • 8% more people being able to meet an unexpected $2,000 expense

For women in particular, this can have a great impact on financial independence and future success. A recent study by HerMoney and the Alliance for Lifetime Income shows that almost all women who have a spouse/partner manage all aspects of their money. 94% say they manage their household finances, investments, and retirement planning (2021 Ms. Independent Survey).

Right Brain, Left Brain

Once you learn the fundamentals of financial literacy, consider one other important thing – your emotions. Psychology and your subsequent behavior turn out to be a very important parts of financial outcomes and how you manage your money. Take for instance the groundbreaking (and Nobel Prize winning) research done by Psychologists Daniel Kahneman and Amos Tversky. In their 1979 paper, Prospect Theory: A Study of Decision Making Under Risk, they present the concept of “loss aversion” bias – the idea that you will be driven twice as much to avoid loss than you will to seek a gain. This can help explain why you may be inclined to sell when the markets are declining (to avoid an even bigger loss) or why you keep long term investments in low earning cash. Your emotions also play a big role when it comes to how you think about your future and planning your retirement.

WATCH Your Money Map: Financial Literacy: UNderstanding market swings

Sarah Newcomb, Director of Behavioral Science at Morningstar, joined Jean Chatzky on Your Money Map to discuss financial literacy and understanding market swings on April 21, 2022.

Covid Conundrum

The psychological stress and existential crisis caused by the pandemic is a key factor why there were 2.4 million early retirements in 2021 – people wanted to make memories, not money. This may have been a good decision if you were prepared to fund a 30+ year retirement, but it could be a bad decision if you haven’t lined-up the necessary income sources you’ll need, and paying particular attention to those sources of protected income that you can count on. Added to this conundrum is the current high level of inflation. While experts forecast this will normalize eventually, one of the foundations of financial literacy, compound interest, helps explain how even a modest rate of 3% can impact your retirement years. A rule of thumb tells us 3% will double your money every 25 years: $100,000 today will be $200,000 in 25 years and $400,000 in 50 years. But when it comes to spending, this means your money needs to grow to this amount just to maintain purchasing power. An easy way to see this is to use a future value calculation tool.

The Time Machine

Unfortunately, research teaches us that most people tend to be short term thinkers, not long-term planners.  One way to “hack” this behavior is to get connected to your future self. Set aside 15 -20 minutes to picture in detail what a full day would look like when you are retired. Where are you living? A city? The suburbs? Are you living in a house? A condo? What does your décor look like? Who are you living with? A spouse? Your children? Alone? This can give you a much better idea of how you want to live and help identify the financial goals which will get you there. A trained financial professional can be a great resource to help you with this exercise. Psychologists also find an age progression tool can help you be more invested in your future outcomes when you can see your future self today.

Weathering the Storm

No matter what, it is helpful to remember that this is an odd time of uncertainty. And uncertainty is stressful. In fact, humans have been shown to prefer even physical pain to the stress of uncertainty, but now is not the time to make rash investment decisions that you might soon regret. Here are some reminders:

  • Losses are a regular part of every successful investor’s experience.
  • Loss isn’t always a sign of bad decisions; it can be simply a byproduct of things like market volatility.
  • Ease the fear of losses by making sure you’ve properly diversified your investments.
  • If you are especially loss averse, having an emergency fund that is in Treasuries or other safe investments can help you rest assured that even when moderate market losses happen, you’ve got plenty of solvency in the short and medium term to get you through.
  • If you’re worried about your retirement portfolio, one of the most effective ways to protect yourself from volatile markets and uncertainty is to add an annuity to your portfolio, which will give you a guaranteed stream of income you can count on each month for the rest of your life.

Behavioral Economist, Sarah Newcomb, offers some healthy food for thought to help you keep your head while others are losing theirs (and possibly blaming it on you):

  • Be wary of doomsday headlines
  • Beware of short-term thinking
  •  Be sure to diversify your portfolio
  • Be patient

Sarah Newcomb is a behavioral economist at Morningstar, where she works to integrate findings from behavioral science into financial management applications for individuals and financial advisors. Her research interests focus on the effects of social and cognitive psychology on personal financial decision-making. She is also author of Loaded: Money, Psychology, and How to Get Ahead without Leaving Your Values Behind.

Learn more at www.allianceforlifetimeincome.org and www.protectedincome.org about building greater financial literacy and steps to plans towards protected income.

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