5 Components of Financial Literacy

What is Financial Literacy? 

Imagine sitting at a dinner party with one engineer, one zoologist, two physicians, and an artist.  This isn’t the start of a bad joke. But imagine the struggle of getting through your meal if each of the guests speaks in their own language. The zoologist and the physician will be using terms that mean absolutely nothing to each other. Often people don’t realize just how many industry-specific terms they use when communicating. People in finance are particularly guilty of this. 

The first time you hear words like mutual funds, dividends, or compounded interest, they sound finance-y and intellectual, but even exceptionally bright people have no idea what they mean. The major caveat about finance is that it has a personal impact on every person. 

A lack of understanding of an artist’s work doesn’t directly impact your future, but if you’re a high earner looking to make your money grow, having a solid understanding of the finance vocabulary is critical. 

Five core areas make up this foundation when it comes to financial literacy. By understanding how each of them applies to your finances, you can set a baseline for your wealth goals and how they will be accomplished. 

5 Components of Financial Literacy

1. Earn

This is more than just the cash coming into your bank account. Earnings include your investment income, which can include, for example, money in a brokerage account or a retirement account. If it is invested, you may earn interest or dividends that you can include in your total earnings amount. 

Whether you are a salaried employee, work on commission, or are paid through equity, several components go into your financial earnings. 

As you build a baseline for where you stand financially, knowing what you earn is the best place to start because it sets the limits that your expenses cannot exceed. Higher earnings mean bigger room for your expenses. 

Earnings can be variable. While salary is usually consistent throughout each paycheck, many people also experience variable income either in addition to salary or as their primary source. Working on commission can be less predictable than salary but may have the potential for higher earnings overall. All commission should be included in earnings. 

Calculating your earnings when you have variable income can be tricky, but it can determine how you look at the following four components once it’s calculated. 

2. Spend

The second component of financial literacy is spending, meaning the money that leaves your bank account. If you don’t have a handle on how much money you spend, this may be the most intimidating part of your financial life. Knowing what you pay is not the same thing as living frugally. This is a common misconception. And just because you know your spending habits doesn’t necessarily mean you need to change them. 

Being financially literate and, quite frankly, financially responsible means knowing what your expenses are and predicting and preparing for upcoming expenses reasonably.

The best place to start is to categorize your expenses between fixed and variable. Fixed expenses are the things that stay the same month to month (mortgage, debt payments, cell phone bill, etc.), while variable expenses will vary month to month (food, entertainment, travel, etc.). 

3. Save

We all know that saving money is essential. But saving money without a goal becomes futile. As a reminder, saving is the excess earnings you put into an account for a future purpose.

There is an element of deferred gratification tied to the concept. Saving income for the bill due next week is not savings. The most common event that people save for is retirement. While this is a very long-term goal, you can also create smaller, shorter-term goals along the way as well. 

You are saving to buy your dream vacation home, saving for that amazing European vacation you’ve always wanted, or saving to give your kids a debt-free education. Regardless of the goal, savings needs to have a purpose. Hoarding money for security is typically a sign of bigger financial insecurity.

4. Invest

Invest comes fourth in financial literacy for a reason. It’s crucial to understand your earnings, spending, and savings before moving on to investing. 

While this is the sexy part of personal finance, it can’t be done in isolation. Investing is a way to help your savings grow and compound over the long term. The concept of investing may be easily understandable, but the actual implementation and monitoring are more daunting. 

There are innumerable options on what you can invest in. However, the decision should ultimately align with the goal of your investments. The plan should include the purpose and the time horizon, numerical target, and risk tolerance. Does that sound a little complicated? You can dive deeper into investment 101 here. 

5. Protect

Now that you’ve got a solid understanding of financial terms, and know where you currently stand, take the next step to protect your wealth. 

It’s simple to protect your wealth from foreseeable threats, like locking valuables in a safe or not leaving your cash in the seat of your car. However, it’s the unforeseen threats that add complexity to wealth protection. 

Protection can involve risk management from creditors, volatile markets, and lawsuits. It can also include insurance, like life insurance, to protect against the potential loss of income if you were to die prematurely. 

Financial Literacy in Summary 

Money is complicated. As a high earner, sometimes you may think you have your finances under control. But if you want your money to grow, your best bet is to set up a strategy based on your wealth goals and incorporate the five components above. There are so many things to consider when it comes to your financial life. It may sound like a full-time job!

The good news is there are professionals ready to help you tackle these aspects and set you up for financial success. Understanding the areas of earning, spending, saving, investing, and protecting your wealth is the best first step to becoming financially literate and accelerating your way to wealth.