If ever you needed an incentive to learn more about money, this might be it. A new study shows that the more financially savvy you are, the more you’ll earn on your 401(k) plan. And not just a little bit more, a whole lot more–up to 1.3 percentage points more per year on your retirement plan investments than your less sophisticated counterparts.
In fact, being financially literate could help you build over the course of a 30-year working career a retirement fund some 25% larger than that of less-knowledgeable peers, according to the study, “Financial Knowledge and 401(k) Investment Performance,” which was recently published as a working paper on the National Bureau of Economic Research website.
For example: If you’re financially smart you might accumulate $625,000 in your 401(k) plan while those less smart about money might accumulate just $500,000, or $125,000 less.
One reason why the financially knowledgeable earn higher rates of return has to do with the makeup of their portfolios.
They own more stocks and can expect higher risk-adjusted returns, according to the study. In fact, the most financially knowledgeable in the study owned 11.5% more stock than their less smart peers, and that accounts for about 1 percentage point of their better returns. Money-smart 401(k) plan participants invested on average 61.4% of their retirement plan in stocks.
All of that makes more sense to some investors: Stocks, though volatile, have returned on average a tad more than 9% since 1993, while low-risk money market funds, which aren’t nearly as volatile as stocks, returned just 3% per year.
Clearly, savvy 401(k) participants are merely taking advantage of the potential for greater returns that comes with investing a greater percentage of their retirement plan in risky assets.
However, being financially smart doesn’t necessarily make you a prudent investor. They may select more volatile portfolios and their investments are more concentrated, as compared to their counterparts in that they think they are better at predicting market outcomes; yet having some knowledge is not strongly associated with most performance measures; rather it’s the best informed who are different.
Take the quiz (see below) from the study to measure your financial knowledge. Consider yourself financially knowledgeable if you answer four or five of the questions correctly.
Financial Knowledge Quiz
How many of the below questions can you answer correctly? The more you get right, you’re more likely you are to outperform those who are less financially savvy. (Answers are below.)
1 – Interest Rate: Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?
a. More than $110
b. Exactly $110
c. Less than $110
2 – Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?
a. More than today
b. Exactly the same
c. Less than today
3 – Risk: Is this statement True or False? Buying a single company’s stock usually provides a safer return than a stock mutual fund.
a. True
b. False
4 – Tax Offset: Assume you were in the 25% tax bracket (you pay $0.25 in tax for each dollar earned) and you contributed $100 pretax to an employer’s 401(k) plan. Your take-home pay (what’s in your paycheck after all taxes and other payments are taken out) will then:
a. Decline by $100
b. Decline by $75
c. Decline by $50
5 – Match: Assume that an employer matched employee contributions dollar for dollar. If the employee contributed $100 to the 401(k) plan, the account balance in the plan including that contribution would:
a. Increase by $50
b. Increase by $100
c. Increase by $200
d. Remain the same
Editor’s note: The first question measures peoples’ ability to do a simple interest rate calculation; the second tests peoples’ understanding of inflation; and the third is a joint test of knowledge about “stocks” and “stock mutual funds” as well as risk diversification, since the correct response requires the respondent to know both what a stock is and that a mutual fund is comprised of many stocks.
Answers: 1,a; 2, c; 3, b; 4, b; 5, c.
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