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Key Financial Literacy Concepts

June 2013

Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension

Want to improve your finances? Learn more about personal finance. In the aftermath of the financial crisis, increasing attention has been paid to financial literacy education. As a result, schools in many states are implementing courses to prepare students for a financially secure life. Below are ten key concepts that students and financially savvy adults need to know:

  • Pay Yourself First (PYF) - PYF means making savings a priority “expense” and saving money before spending it on goods and services. The best way to PYF is to have savings withheld from your paycheck and automatically deposited into a savings or investment account (e.g., 401(k) retirement savings plan).
  • Human Capital - The phrase “human capital” refers to all the attributes that people can offer to an employer. It includes their knowledge, skills, experiences, professional contacts, and good health. Human capital is developed through both formal and informal education and life experiences. Generally, when people learn more (e.g., through a trade school certificate or college degree), they earn more.
  • Wealth-Building Strategies - According to the Council for Economic Education’s high school curriculum, Learning, Earning, and Investing, there are three rules for wealth-building over time: start investing early, buy and hold (i.e., keep your money invested), and diversify your portfolio.
  • Compound Interest - When people save money, they earn interest. If this interest is not spent, it compounds and savers earn interest on interest. Compound interest is “free money” and will increase a person’s total savings accumulation over time. The same is true for investors who reinvest stock and mutual fund dividend and/or capital gains distributions in additional shares that later grow in value.
  • Credit - Credit is the present use of other people’s money (e.g., a bank or credit card company) and is useful for emergencies and to purchase “big ticket” items. However, interest increases the cost of purchases made with credit and credit use can lead to overspending and missed savings opportunities.
  • Opportunity Cost - Opportunity cost is the next best alternative that a person gives up when they make a decision to do something. In other words, what you don’t do when you do something else. For example, if someone makes a $25 charitable donation, that money is not available to save or spend. Every day, people make dozens of opportunity cost trade-offs when they decide how to use their money and time.
  • Financial Goal-Setting - To be “actionable,” financial goals should have a specific dollar cost and time frame such a “Save $8,000 to buy a new car in 4 years.” Short-term goals can be achieved in less than one year, medium-term goals in one-to-five years, and long-term goals in more than five years.
  • Diversification - Investors diversify their investments by “not putting all their eggs in one basket.” In other words, investment risk is reduced by selecting different types of investments and different securities within each type (e.g., stocks from companies in different industry sectors such as health care and technology or stocks from different countries around the world).
  • Risk-Reward Relationship - Generally, the more uncertain the return on an investment, the higher its risk (of losing money) and potential rate of return. This relationship is typically depicted with a pyramid that shows low-risk cash assets at the base of the pyramid and higher risk stocks, real estate, derivative securities, and commodities toward the top.
  • Rule of 72 - The Rule of 72 is a frequently cited mathematical formula that is used to determine the amount of time or interest rate (rate of return) required to double a sum of money. To do a Rule of 72 calculation, divide 72 by the interest rate earned on savings or an investment to determine the number of years it will take or divide 72 by the number of years to determine the required interest rate.