Educated persons found lacking financial literacy, often!

Here are five key constituents of financial literacy which investors needs to equip with, in order to become financial literate

Financial literacy is the key to the empowerment of investors and helps in developing a healthy financial system. It has been often seen that in absence of financial literacy, many

investors often get cheated. This applies to even otherwise educated persons, who are found lacking in financial literacy. So what is financial literacyand what are the key constituents of financial literacy. The President's Advisory Council onFinancial Literacy in US defines personal financial literacy as "the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial well-being." This definition gives a clear cut understanding of financial literacyand emphasises the fact that certain types of knowledge and skills are required to become financial literate. While the definition has been used in the context of US, in the context of India, the situation can be different, although the basic tenets of financial literacy remain the same.

What are the key requirements to be financially literate? How can an individual acquire skills and knowledge to make him financial literate? Here are five key constituents offinancial literacy which investors need to equip with, in order to become financial literate:

Understanding compounding and discounting

Every investor needs to understand how his investment generates return. In order to understand this, it is important that every investor understands how compounding works. Compounding gives an accumulated value of an investment considering reinvestment periodically. While it is possible for some investors to understand compounding as we read this during school days, discounting is very difficult to understand. Discounting helps in identifying present value of investments which is the key to compare returns like compounding. These days excel functions are available to understand compounding and discounting which every investor needs to familiarize himself with.

Understanding difference between savings and investments

Savings in itself is not enough and investors need to convert savings into investments. Savings are a part of money which an investor has to keep to meet short-term requirements. Savings are liquid funds which are maintained in order to meet some immediate returns while investments have long term horizon. Investments are driven by wealth-building objectives. It is important that investors invest their money in those investments which not only generate long term returns but also help them beat inflation. Inflation adjusted returns (often called as real returns) should be the driver of every investment objective.

Understanding risk and return of investments

Before making investments, an investor should understand the risk and return of investments. This is one of the most important components of financial literacy. Investments like equity carry high risk and have potential to generate high returns. However, it is important to note that taking high risk does not result into high returns essentially. Since risky investments carry potential of capital erosion, investors should understand risk element before making investments. If any entity is ready to offer an investor a very high return, then that investment should be avoided. Anybody offering an extremely high rate of return is generally desperate to borrow. Also, it is important to understand that projected returns in an investment are not the real return.

Understanding financial products

There are various financial products on offer in financial markets. While it is difficult to understand all these financial products, it is critical to understand plain vanilla financial products available in the financial market. Understanding financial products equips an investor to take informed decisions. The key objective of having this understanding is to select products which suit the requirements of investors. One of the key things thatfinancial literacy equips an investor with is that one should never venture into those financial products in which an investor does not invest.

Understanding protectors of financial system

As part of financial literacy, one must understand as to who are the protectors of financial system.. These institutions are often called as regulators. While regulators may not help solve all financial woes of an investor, they are definitely the first step in solving financial grievances.

While there are various other aspects of financial literacy, it is important to equip oneself with bare minimum skills and knowledge necessary to become financially literate. Many investors end up losing their hard-earned wealth in the absence of financial literacy, so it is better that one equips oneself with financial literacy.