Financial Literacy has become a hot topic in the last couple of decades and it seems perfect to kick off this blog. Although I wasn’t old enough to fully experience it, it seems that while the sun was shining, Financial Literacy was not regarded as being that relevant. Enter 2008 – the Global Financial Crisis hits the shore, brings with it years of lackluster growth across the Western World and, when things were looking a bit brighter, a widespread housing crisis with a double-digit inflation topping makes us all feel like our future is doomed. This has been and still is, unfortunately, the reality in Europe, but there’s certainly a lot that each individual can do to improve its chances of financial success. After all, economists can show us their fancy medians, standard deviations and moving averages to try to convince us that things are the worse they have ever been (by the way, they aren’t), but they cannot force you to give up and accept that midiocrity is our destiny. We live in the information age and it is with full confidence that I say that there’s never been a better sustained period of time to generate wealth and get in control of your finances and your future. Don’t take my word for it: according to UBS’ 2024 Global Wealth Report, the World continues to get progressively richer at a real pace of 4.7% per year and in many of the mature economies — where European countries are, for the most part, included — the level of inequality has decreased, signaling greater upward wealth mobility.
Quoting UBS’ Chief Economist Paul Donovan
“Who owns the wealth also evolves, with a surprisingly large group of people moving up out of the lowest wealth bracket over time”
The report also shows that one in three individuals are able to get into a higher wealth band within a decade, indicating that the ever-growing access to information and new technology makes it easier than ever to accumulate wealth with relatively low initial investments.
You may argue that those increases happened mostly in developing countries, and that is certainly true, — after all, relative growth is easier and more noticeable when your starting point is low — but you’ll certainly agree that higher purchasing power anywhere in the world means more potential clients and opportunities for the European economy.
Alright, now that we’ve supported the idea that opportunities exist, where do we stand in terms of capacity to benefit from them? Do we know what to do, are we absolutely clueless or somewhere in between? Well, accordingly to the latest survey from the European Comission, Europeans need to work on their Financial Literacy. Only 25% of respondents managed to get at least a 4 out 5 on the very simple questions that were asked, covering topics such as risk, investments and interest.
Luxembourg managed to do a bit better, but for a country that is so heavily concentrated on the Financial industry, I would certainly expect better results. In fact, only one third of the population got 4 or more answers right, which is not that much higher than the rest of Europe.
The same study found that women, young people, people with lower income and people with lower level of education tend to be less financially literate than other groups. In other words, groups that are more vulnerable seem to also lack one important piece of knowledge that could contribute to decrease the gap between them and less vulnerable groups. Those who understand this field own a significant advantage over those who don’t, an advantage that extends far beyond the number that you see in your bank account – afterall, we are talking about a knowledge field that comprises topics such as:
- Personal budgeting
- Spend control
- Savings optimization
- Investing
- Asset allocation
- (Early) Retirement planing
- Risk management
- Mental health
- Carreer opportunities
Good financial decisions compound over time and can make the difference between living one lay-off away from poverty or a thriving and freer life. Let me provide you one very simple example to illustrate the point I’m trying to make:
Picture Maria, a 25 year-old finance professional living in Luxembourg and making enough money to live decently confortably and to still save some money at the end of the month. Let’s suppose that after all of her expenses, Maria manages to save 500€. There are different paths that she can follow in order to have the money working for her, but let’s assume 3 scenarios, each one lasting for 10 years:
1 – Maria saves the 500€ in her bank account, earning 1% interest per year;
2 – Maria saves the 500€ in a savings account with her bank, earning her 3% per year;
3 – Maria invests the 500€ in a diversified, low cost index fund, earning her an average 8% per year;
Let’s also assume monthly compounding, constant nominal savings and a 2% inflation throughout the 10 years.
The chart below represents Maria’s money in each of the scenarios.
Keeping the money in a current account would result in total savings of 63,075€. From that amount, 3,075€ corresponds to passively-generated interest. In all fairness, a very poor return, and it gets even worse when you bake inflation in: at an optimistic 2% inflation rate, Maria would have a negative real return and at the end of the 10 years she would have lost purchase power. To be precise, Maria would have lost 2,880€ of purchasing power.
And I know what you are thinking. No one keeps their savings in a current account. Well, so let’s see what happens when Maria does what most people do. After 10 years putting the money towards a savings account, Maria managed to save 69,871€, generating 9,871€ of passive income and outpacing inflation by 1% per year. As a result, she generated a positive real return (but only a tiny one) of 3,075€.
Now, what we are really interested in is the last scenario. In this scenario Maria did what most people don’t do. She took her hard-earned money and put it to work even harder for her, following some of the best advice out there: she chose a low-cost, broad-based ETF. We are assuming an 8% yearly return, but if this return sounds too optimistic, keep in mind that over the last 10 years, BlackRock’s iShares MSCI World ETF has returned on average 10.3% per year. In this scenario, Maria would have achieved total savings of 91,473€, yielding 31,473€ of passive earnings. In real terms, she made a 6% return, or 21,940€. More than 7 times higher than the savings account.
One may argue that the risk involved in investing in the ETF is substantially higher than leaving the money in the bank, and that cannot be argued against. Equity ETFs are a lot riskier than leaving the money in the bank, specially considering that in Europe, up to 100,000€, your money is safe and the risk is virtually zero. So I went searching and found that, over the last 96 years, 94% of all 10-year periods had positive returns for investors – in my opinion, a really good chance of success.
Looking at the figures, it is tempting to desire the 3rd scenario, but Financial Literacy is more than just aiming for the highest returns. It is necessary to consider risk appetite, investment horizons and investment goals before taking any investment decision. If Maria plans to buy a house in the next 5 years, then investing her money in a Equity ETF would be a lot riskier, as shorther investment periods in stocks decrease the chance of positive returns. In that case, Maria would be better off by keeping her money in a high-yield savings account until she managed to collect enough cash to purchase the house. Although this is a very simple example, life often poses complex challenges that can create a feeling of uncertainity around money (should I buy or lease a new car?; should I buy or rent an apartment?; what type of life insurance is the best?; I’ve received an inheritance – how do I optimize this windfall?). The higher the level of your financial literacy, the better you’ll navigate the doubt and uncertainity that naturally come with such decisions. Our goal here is to help you to continously improve your financial situation and to decide with confidence when those questions appear in your life.
More Financial Literacy brings, when applied properly and consistently, higher levels of personal satisfaction and freedom — very desirable outcomes coming from learning something that is not complex and generally free. Invest in your Financial Literacy – it will have a real, daily, positive impact in your life.