Financial Literacy and Stock Market Participation

Abstract

Individuals are increasingly put in charge of their financial security after retirement. Moreover, the supply of complex financial products has increased considerably over the years. However, we still have little or no information about whether individuals have the financial knowledge and skills to navigate this new financial environment. To better understand financial literacy and its relation to financial decision-making, we have devised two special modules for the DNB Household Survey. We have designed questions to measure numeracy and basic knowledge related to the working of inflation and interest rates, as well as questions to measure more advanced financial knowledge related to financial market instruments (stocks, bonds, and mutual funds). We evaluate the importance of financial literacy by studying its relation to the stock market: Are more financially knowledgeable individuals more likely to hold stocks? To assess the direction of causality, we make use of questions measuring financial knowledge before investing in the stock market. We find that, while the understanding of basic economic concepts related to inflation and interest rate compounding is far from perfect, it outperforms the limited knowledge of stocks and bonds, the concept of risk diversification, and the working of financial markets. We also find that the measurement of financial literacy is very sensitive to the wording of survey questions. This provides additional evidence for limited financial knowledge. Finally, we report evidence of an independent effect of financial literacy on stock market participation: Those who have low financial literacy are significantly less likely to invest in stocks.

Who Lost the Most? Financial Literacy, Cognitive Abilities, and the Financial Crisis

“…Thus, our results are consistent with previous results in the literature, e.g. Calvet et al (2007), van Rooij et al (2007). The main explanation is that financially illiterate households are skeptical about financial markets and thus stay out of risky assets to avoid investment mistakes.…”

“…Thus, we confirm the finding by Calvet et al (2007) and van Rooij et al (2007) that individuals with low levels of financial knowledge stay out of risky assets. We find no effect of financial literacy and IQ on the size of the loss conditional on participation in risky asset markets.…”

“…More-6 See e.g. Guiso and Jappelli (2005), Calvet et al (2007), van Rooij et al (2007), Christiansen et al (2008), Christelis, Jappelli and Padula (2010), McArdle et al (2009), Cole andShastry (2009), andGrinblatt et al (2010).…”

Betting on a Long Life – the Role of Subjective Life Expectancy in the Demand for Private Pension Insurance of German Households

“…The probability of having private pension insurance is about 10 percentage points higher in financially literate than in financially illiterate households which is significant at the 1 percent level. This result is in line with the recent literature on the relationship between financial literacy, retirement planning ability and retirement saving (Lusardi and Mitchell (2006, 2007a, 2007b and van Rooij et al (2007)) and is also supported by Brown et al (2008a) and Bucher-Koenen (2009).…”

The Effect of Education on Equity Holdings

“…Education may lower these fixed costs to the extent that such costs reflect a lack of understanding of or familiarity with stocks. van Rooij, Lusardi, and Alessie (2007) explore the effect of households' financial literacy-the knowledge and understanding of basic financial concepts related to stocks and bonds-on households' stock ownership. Using exposure to economics courses while in high school as an instrument for the respondent's financial literacy, they find a significant and large effect of household's financial knowledge on the probability of owning stock.…”