Test your knowledge of finance with this quiz. Some answers are more “right” than others – pick the best answer. These are “real world” examples, not test questions for a personal finance exam.
Question 1
Mary and Dick file a joint tax return every year. Dick likes to have federal taxes over withheld so that they get a refund every year which is usually around $1000. Mary, who is more financially savvy than her husband, suggests that they adjust their withholding allowances, take that $1000, and invest it every year where she believes she can get a conservative 6% annual return over 20 years. If Mary succeeds in convincing him, about how much money would they have at the end of 20 years:
- about $25,000
- about $30,000
- about $35,000
- more than $35,000.
If they invested the $1000 once a year at 6% they would have $36,785.59 at the end of 20 years compared to Dick’s approach which results in $20,000. They would have a gain of $16,785.59.
Adjusting withholding to break even with the IRS can be a good strategy, otherwise you’re letting the IRS use your money all year long at your expense.
Question 2
Nancy, aged 35 and single with a 10-year-old daughter, has her own housecleaning business with herself as the only employee. She has just bought a house with a $200,000 mortgage and has purchased a $200,000 life insurance policy for herself. Her thinking was to protect her daughter’s future by covering the balance of the mortgage should she die prematurely. Which of these is the best answer:
- Purchasing life insurance was smart to protect her daughter’s future.
- Purchasing life insurance at the age of 35 is throwing money away to insure against a very low probability risk.
- Purchasing insurance was a good idea, but she should have put a higher priority on disability insurance.
- Nancy doesn’t need any type of insurance other than health insurance for her and her daughter.
A typical female, age 35, 5’4″, 125 pounds, non-smoker, who works mostly an office job, with some outdoor physical responsibilities, and who leads a healthy lifestyle, has a 24% chance of becoming disabled for 3 months or longer during her working career with a 38% chance that the disability would last 5 years or longer. A 35-year-old-woman has a 12% chance of dying before reaching age 65. Since Nancy does not have any backup, if she cannot work she loses both her income and possibly her business. She needs health insurance and she should consider disability insurance before any other types of insurance.
When considering insurance, make sure you’re clear on the risk you’re insuring against.
Question 3
Jeff, aged 40 and single, made a good financial decision when he opened a Roth IRA account 10 years ago which now has a balance of $50,000. Of the $50,000 he contributed $40,000 over 5 years with the other $10,000 coming from appreciation of the investments in his account. Now approaching a mid-life crisis, he has decided he’d rather have a new sports car than a Roth account. Which of the following is true?
- Jeff cannot withdraw any of this money because he is not aged 59 ½, a rule dictated by the IRS.
- He can withdraw the entire $50,000 and not pay an IRS penalty.
- He can withdraw some of the $50,000 and not pay an IRS penalty.
- There is not enough information to answer this question.
Jeff can withdraw $40,000 without penalty. Contributions can be withdrawn at any time from Roth IRAs, but appreciation on those contributions is subject to penalties unless specific requirements are met. Buying a new car at age 40 does not meet any of the IRS rules for exceptions.
Try to avoid a mid-life crisis.
Question 4
Jennifer, aged 25, has graduated from college and has had the good fortune to find a fulltime job with a company that offers a 401(k) plan. Her company will match, dollar for dollar, up to 3% of her annual salary which is $30,000. She decides not to participate in the company’s 401(k) plan because she doesn’t think she’ll be working there for more than a few years. But she does plan on putting 3% of her yearly salary into a mutual fund in a taxable account she plans to open, with deposits made monthly. Assuming a 6% investment return for the 401(k) plan as well as for her newly-opened taxable fund, about how much is she foregoing if she stays at her job 5 years and doesn’t enroll in the company’s plan?
- Not very much, and that justifies not enrolling in the 401(k) plan.
- $4,500.00
- $4,635.35
- There is not enough information to answer this question.
Answer “3” would be correct except for two things: it does not take into account any salary increases Jennifer might get over that 5-year period, and it ignores the taxes she would save by enrolling in a tax-deferred plan such as a 401(k). Taking both into account, the amount she is foregoing would exceed answer “3” by an undetermined amount. There is not enough information to answer the question.
Don’t ignore a company’s 401(k) plan just because you’re young.
Question 5
George’s investment portfolio ran head first into a stock market crash, resulting in his investments losing 50% of their value. What percentage increase must his portfolio subsequently regain to be back to where it was prior to the crash?
- 50%
- 75%
- 100%
- 150%
- 200%
If George loses 50% of a $10,000 portfolio, he loses $5,000. To recover this $5,000, he needs a subsequent gain of 100%.
This is a good example never to forget as there have been 50% and worse crashes in the history of the US stock market. If your investments are 100% in stocks you should either be prepared to endure substantial losses at some point, or you should better diversify your investments by adding bonds or other appropriate investment vehicles.
Question 6
Ron is computing the 5-year return on his portfolio. In the first year he got a 10% return, followed by 20%, minus 20%, minus 10%, and 0%. He computes his average return as 0 for that 5-year period. But when he looks at his latest broker statement, his current balance is less than it was 5 years ago; he is down about 5%. The reason is:
- Ron is getting unreliable account balances from his broker.
- Ron is math challenged.
- The broker has subtracted a 1% asset management fee every year.
- Ron computed an arithmetic mean when he should have computed a geometric mean.
Ron is not math challenged but he is however making a common mistake. While his average return is 0 just as he computed he needs to compute the actual return this way: 110% times 120% times 80% times 90% times 100%. This can be rewritten as 1.1 X 1.2 X .8 X .9 X 1.0 = .9504. If one or more of the returns is negative, then a geometric mean will always be lower than the arithmetic mean. Mutual funds report their 3, 5, and 10-year performance results using arithmetic means – it’s hardly surprising as to why they do so.
Don’t be mislead by statements made in the financial media.
Question 7
Susan loves new cars. She’s thinking of buying a new car for $50,000. She does her research, checks Edmund’s, and discovers that cars depreciate on average 19% after one year, 31% after two years, 42% after 3 years, 51% after 4 years, and 60% after 5 years, meaning her new $50,000 car would be worth about $20,000 after 5 years. The used car she’s looking at is 3 years old and costs $29,000. She plans on keeping her next car about 3 years before turning it in and wants to keep her monthly payments down by taking out a 60-month loan. She can get an interest rate of 3.54% on a new car 60-month loan, and an interest rate of 4.14% on a used car 60-month loan. Assuming she does trade 3 years later, which is the better choice for Susan right now?
- The new car because the interest rate is lower.
- The new car because the trade in value will be higher after 3 years have elapsed.
- There will not be an appreciable difference in her cost since she plans to trade the car in 3 years.
- The used car, as she will be better off by over $10,000 when she trades it compared to the new car.
- There is not enough information to answer this question.
The new car will be worth $29,000 after 3 years, she will have paid the bank $32,793.48, and she will still owe the bank $21,072.06, the remaining balance on her loan. She now has a $29,000 asset which has cost her $53,865.54.
The used car will be worth $20,000 after 3 years, she will have paid the bank $19,292.76, and she will still owe the bank $12,323.45, the remaining balance on her loan. She now has a $20,000 asset which has cost her $31,616.21.
After 3 years the used car will be worth $9,000 less than the new one, but it will have cost her $22,249.33 less, so she is better off buying the used car by $13,249.33. Buying the new car will cost her about $368 more per month than the used one ($13,249.33/36).
Financing a depreciating asset should be avoided if possible. But if you must, find a way to think about your options carefully before visiting a car dealership.
Question 8
John, aged 30, is planning to retire in 30 years at age 60. He says he cannot afford to begin setting aside money now, so he plans to fund his retirement savings by setting aside money in his 50s when he expects to be making a lot more money and can therefore afford to save a lot more money. Assuming he wants to have $500,000 in his retirement savings at age 60, and assuming he can get a 6% annual return on his investments, how much more will he have to save every month in his 50s than if he had started 20 years earlier at age 30?
- about $497 per month
- about $1,000 per month
- about $1,500 per month
- about $2,000 per month
- over $2,500 per month
To reach John’s $500,000 goal assuming a 6% annual return requires a monthly contribution of $497.75 for 30 years. To reach the same goal in 10 years requires a monthly contribution of $3,051.02. He would have to save about $2,553 more per month if he delays putting money aside until he reaches age 50. Einstein is sometimes credited with characterizing “compounding” as the eighth wonder of the world.
It pays to start early.
Question 9
Sarah is justly proud of herself for having saved $20,000 by the age of 30. A friend of hers recommends that she take this amount to a financial planner she knows who will invest Sarah’s $20K and manage it for her. She agrees and is told by this planner that he will be happy to assist her, will charge her a fee of 1% per year on the total of her investments, and will invest her money in 5 or so stock mutual funds that are diversified. She agrees. The adviser then picks 5 mutual funds each of which is a load fund, meaning 5% of her $20,000 is taken right off the top and shared as fees between the adviser and the 5 fund companies. Note this is on top of the annual 1% asset management fee. How should Sarah feel about this?
- She should be fine with this as the fees are reasonable and won’t make much difference over time. And she’s optimistic that her adviser is likely to beat the market in both the short and long terms.
- She should find another adviser as she has already lost an amount money that will make a very large difference over her investing lifetime.
- She should do a bit of research on no-load, low cost stock index mutual funds and make her own investment decisions.
- She should find a fee-only financial planner who acts as a fiduciary, and who has a demonstrated track record of making good investment recommendations to clients. Spend an hour with this person, and then decide how she wants to proceed.
If she sticks with her current adviser she will have $66,227 after 30 years. This is after taking out ongoing adviser fees, the 5% upfront load, and assumes 0.75% annual mutual fund fees. It does not account for yearly taxes that need to be paid from the mutual fund taxable distributions.
If she instead puts the original $20,000 in a low cost no-load index fund like the Vanguard 500 Index Fund, she will have $113,577 after 30 years; a gain of $47,350 or $1,578 every year. This result is after taking out the 0.04% Vanguard mutual fund fee. Like the other example, it does not account for yearly taxes that need to be paid from the mutual fund taxable distributions. However, since this is an index fund with low turnover, these taxes will almost certainly be less than the taxable income generated by actively managed funds due to their high turnover caused by frequent buying and selling.
If she had started with $100,000 instead of $20,000, she would have $331,135 and $567,883, respectively, after 30 years. The difference, $236,747, is because of the fees paid and the compounding effect of paying them over time. And contrary to what you might have heard (see answer “1”), the odds of any adviser beating the market over long periods of time are virtually zero.
Costs matter, a lot. Please choose answer “4”.