The Big Three Explained
The Big Three—a trio of financial literacy questions—evaluate understanding of compound interest, inflation, and risk diversification, three fundamental financial concepts that we encourage you to learn about, as they are stepping stones to sound financial decision-making. You can gain understanding of these concepts by checking out the correct answer to each of the Big Three questions and the explanations for those answers.
Question #1: Compound Interest
Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
• More than $102
• Exactly $102
• Less than $102
• Don’t know
Correct answer: More than $102
Explanation: Interest builds on interest over time—this phenomenon is known as compound interest. In the first year, you earn 2% of $100, or $2 in interest. In the second year, you earn 2% of $102 (your balance after the first year), or $2.04. This process continues, and after five years, you will have $110.41.
Question #2: Inflation
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with money in this account?
• More than today
• Exactly the same as today
• Less than today
• Don’t know
Correct answer: Less than today
Explanation: Inflation, the general increase in prices in the economy, erodes your ability to buy things. If the interest rate on your savings account is less than the inflation rate, your ability to buy things will decrease.
Question #3: Risk Diversification
Do you think the following statement is true or false? ‘Buying a single company stock usually provides a safer return than a stock mutual fund.’
• True
• False
• Don’t know
Correct answer: False
Explanation: Buying individual stocks is typically very risky, as prices can fluctuate significantly. Stock mutual funds typically contain many stocks of companies from different industries, which lowers the fluctuation of the fund’s price. This is the concept of diversification at work.
The Big Three in Practice
You should apply the three fundamental financial concepts covered by the Big Three when making everyday financial decisions. We present you with three stories in which characters apply these concepts to make better decisions. These stories will also help you gain a deeper understanding of compound interest, inflation, and risk diversification.
Our research suggests that to make better decisions in complex financial situations, an understanding of all three concepts is important, so don’t skip a story. And refreshing your knowledge by revisiting the stories is crucial, so set a reminder to reread them.
Check the stories out!
Compound Interest
Learn how Michelle and Dave make a small fortune from their wedding gift, simply by understanding the power of interest compounding.
Read the story
Inflation
Learn how a plaid shirt inspires Lisa to save more for the future by making her realize the eroding power of inflation.
Risk Diversification
Learn how Kate convinces her husband, Sam, not to put all their eggs in one basket.
Go Deeper
Everything we do at IFDM is deeply rooted in research. And our research shows that financial literacy, represented by the ability to answer all the Big Three questions correctly, has important benefits across a wide range of financial outcomes. Our research suggests that financial literacy is associated with
- Higher wealth accumulation over one's lifetime.
- Better preparedness for financial shocks (financial resilience).
- Better debt management.
- Investing in the stock market.
- Timely planning for retirement.
We have studied how stories explaining concepts of compound interest, inflation, and risk diversification affect financial knowledge and behavior. Our findings suggest that reading the stories significantly improves understanding of these concepts. Moreover, we show that revisiting the stories is important for the long-lasting effect, and that the understanding of all three concepts together is important.
Want to learn about the state of financial literacy in the U.S.?
Check out our interactive tool to explore how much people know about compound interest, inflation, and risk diversification.