If you want to see how well you understand general investing concepts like inflation and compound interest, you can take a conventional financial literacy test like this eight-question version from AllianceBernstein. But if you want to see whether you possess the combination of common sense and numbers savvy that’s crucial to making wise financial decisions, check out my 10-question “Street Smarts” quiz.
1. A guest on a TV investment show raves about a stock he says is a terrific bargain and few investors know about. What do you do?
a. Buy it quickly before other investors drive up the price.
b. Consult your uncle Barney—he’s always trading stocks online.
c. See what the Twittersphere has to say about the company.
d. Do nothing because you realize that by the time some investing pundit is touting a stock on TV it’s chances of being a true bargain are nil.
2. If an adviser tells you that he’s a fiduciary, you can rest assured that you’ll get unbiased advice at a fair price because a fiduciary is required to put your interests first.
3. A letter arrives inviting you to a free-lunch investment seminar featuring a lineup of experts who promise to impart sage counsel on everything from investing your savings to ensuring you don’t outlive your nest egg. After reading the invitation you…
a. Make a reservation ASAP as the invitation does say, “Seating is limited!”
b. Decide to attend to grab a free lunch even though you’re not sure this event is on the up and up.
c. Throw the invitation in the trash because you know that free-lunch seminars can be hunting grounds for salespeople pitching dubious products and services.
4. Withdrawals from a traditional IRA are taxed, while draws from a Roth IRA can be tax free. Therefore, a Roth IRA is a better choice than a traditional IRA.
5. You buy an ETF that was up big time recently, but in the year after you buy, it drops 40%. You hold on, however, and the next year it rallies for a 40% gain. At this point you are…
a. Back to even
b. Ahead of where you started
c. Behind where you started
d. Holding on for dear life
6. If your 401(k) plan offers a dozen or so investments, you’re probably better off putting at least some money in all of the options. After all, the more you diversify, the better off you’ll be.
7. The percentage of salary you need to save each year for a comfortable retirement depends on…
a. Your age
b. Your income
c. How much you’ve already saved so far
d. All of the above and more
8. When choosing a mutual fund (or ETF), it’s okay to focus solely on returns and ignore the fund’s expenses since annual fees have already been deducted in calculating a fund’s gains or losses.
9. An adviser tells you about an investment that offers the upside of the stock market but also promises a guaranteed minimum return to protect you against market setbacks. Your reaction is…
a. Sign me up!
b. There must be a catch. All-gain-no-pain investments don’t exist in the real world.
10. The best way to ensure you don’t outlive your retirement savings is to…
1. d. Do nothing. By the time you hear about a stock or almost any investment on a TV show or in the financial press, its price probably already reflects the consensus judgment of the market. So unless you have some unique insight that you feel other investors have missed, your chances of grabbing a true bargain no matter how quickly you buy are slim at best.
2. b. False. Whatever the merits of the Department of Labor’s and SEC’s efforts to require a fiduciary standard for advice, the fact remains that just because an adviser is bound by such a standard doesn’t guarantee honesty or unbiased advice. As a registered investment adviser, Bernie Madoff had a fiduciary duty to his clients. What’s more, there’s no way to eliminate all conflicts between an adviser and an investor. So whether you’re dealing with a fiduciary or not, you should take care to vet an adviser’s background and compare his fees to those of other advisers offering comparable products and services.
3. c. Throw it away. I’m not saying it’s impossible one could come away with sage advice attending a free-lunch investment seminar. But a report the Securities and Exchange Commission issued after surveying 110 securities firms and branch offices that offered such seminars found that “100% of the ‘seminars’ were instead sales presentations” and that “50% featured exaggerated or misleading advertising claims.” If you do decide to attend such a seminar for the free food, just make sure that you don’t end up being the main course.
4. b. False. First of all, not all Roth withdrawals are income tax free. (For a rundown on Roth withdrawal rules, check out Fairmark.com.) But even if your withdrawals will escape taxes, that doesn’t necessarily make a Roth a better deal than a traditional IRA. Although other factors can come into play, the biggest is whether you’ll face a higher marginal tax rate when you withdraw money than when you contribute it. If that’s not the case, a traditional IRA is typically a better bet. Morningstar’s IRA Calculator can help you decide which is the right choice for you (although it can also pay to diversify your tax exposure and have at least some money in both traditional and Roth accounts).
5. c. Behind. Simple arithmetic proves this is the case. If you invest, say, $100 and lose 40%, you now have $60. If your $60 then rises 40%, your $24 gain brings your investment’s value to $84, leaving you with a 16% loss on your original $100 investment. The bigger point here, though, is that the more volatile the investments you own, the bigger the gain that’s required to recover from losses. In this case, getting back to even after a 40% loss requires a gain of 67%. If you can’t handle a white-knuckle ride, you should build a portfolio that’s less prone to dramatic swings.
6. b. False. Spreading your money among all the investing options our 401(k) offers no more guarantees a well-balanced portfolio than choosing every dish at a smorgasbord buffet means you’re eating a balanced diet. And while it’s true that diversifying does reduce risk, it’s also possible to overdo it and “di-worse-ify.” Fortunately, you can get pretty much all the diversification you need by investing in a few broad-based stock and bond index funds.
7. d. All of the above and more. While you often hear that one should invest 10% or 15% a year for retirement, the truth is that your savings target can depend on, among other things, how early you get started saving, how much money you make, how much you already have in retirement accounts and how you invest your savings. This retirement income calculator can help you arrive at a reasonable savings target based on your situation.
8. b. False. While it’s true that mutual fund and ETF returns are quoted net of annual fees (although front-end and/or back-end sales charges may still apply), that doesn’t mean you should ignore fees when choosing funds or ETFs. The reason: research from Morningstar as well as others shows that low-fee funds tend to outperform their high-fee counterparts, which means focusing on low-cost options like index funds can likely lead to a larger nest egg and increase the odds your savings will support you throughout retirement.
9. b. There’s gotta be a catch. Guarantees sound great—and in the right circumstances can be—but there’s always an offsetting cost, whether it’s capping the potential gain, levying a fee if you withdraw your money or otherwise restricting access to your funds. Before you buy an investment because of a guarantee, make sure you know exactly what is being guaranteed, what’s backing that guarantee and what you’re giving up to get it.
10. d. None of the above. Technically, I suppose dying early is also a correct answer, but I doubt many people consider it a palatable choice. The other options also have downsides. The 4% rule doesn’t guarantee you won’t run through your savings, plus it has other drawbacks. And while an immediate annuity does make payments as long as you live, you also lose access to the money you invest, which means you wouldn’t want to invest all, or probably even most, of your savings in one. Which is why the best way to ensure you don’t outlive your savings is to do a retirement budget and create a retirement income plan that, depending on your circumstances, may or may not involve putting a portion of your savings in an annuity.
Scoring: Give yourself 10 points for each correct answer.
100 points: You the man! You have true financial street cred and seem to be well-equipped for making smart financial decisions.
70-90: You’ve got a decent command of how the financial world works, but apparently still have a few blind spots.
40-60: You clearly need to bone up on investing basics and develop a more realistic view of how to achieve financial success.
0-30: I guess the charitable way to put it is that you have lots of room to improve and develop some financial street smarts. In the meantime, don’t attend any free-lunch seminars.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. You can tweet Walter at @RealDealRetire.
More From RealDealRetirement.com