The Effect Of Financial Literacy

Published Date: 02 Nov 2017

1. Introduction

In the wake of the credit crisis many have pointed their arrows towards the institutions and legal bodies in denouncing their discontent with the current state of affairs with regards to the financial system. Given the current developments in the market system like liberalization and several structural reforms regarding Social security and pensions, the case could however be made that in the last years responsibilities for private individuals have increased and the role they played is larger than often acknowledged by themselves as well as the government. Given the aforementioned reasons, people need to be more participative in the process and preservation of their financial well-being. To be able to participate and make well-rounded decisions people require a sufficient understanding of financial concepts, theories and processes. In other words, the market reforms demand a higher level of financial literacy from private individuals in order for them to financially prepare for the future. The question is whether the individuals mentioned are well-equipped enough to do just that.

Poorly informed people make poor financial decisions, whilst often disregarding their own position including responsibilities and obligations. In the literature on this topic several studies show that financial illiteracy is more than often, if not always, accompanied by poor decisions on mortgages (Moore, 2003), as well as excessive debt accumulation and insufficient retirement saving (Lusardi and Mitchell, 2007b). It is also shown that this financial illiteracy is widespread and knowledge of the most basic principles of finance is deficient amongst most people. (Lusardi and Mitchell, 2006, 2007a). It also proves that in the stock market, individuals who are less sophisticated concerning financial theory will be less likely to invest in stocks, whilst it may be optimal if they did the opposite. (Lusardi, Alessie and van Rooij, 2007).

In assessing the effect of financial literacy on accumulated wealth of individuals, the survey modules of Lusardi et al. (2007) will be considered to aptly measure the level of financial literacy in the course of this research. The questions are divided into two specific categories and are designed to construct two indices of financial literacy. The modules are taken into account due to the simplistic nature of the questions, the general applicability of these modules, and the given fact that these modules were originally designed to suit the Dutch population.

The survey modules will be supplemented by additional general questions inquiring about diverse wealth attributes, such as savings, mortgages and retirement funds, thus covering additional elements deserving of attention with regards to the scope of this research, e.g. knowledge of mortgages, pension system concepts and propensity to save. This refers especially to the advanced financial literacy index, which will be subject to revision. This data will be combined with the results of the financial indices as to be able to make inferences about financial literacy and the correlation towards wealth accumulation.

The focus will be set upon not only the long-term saving behavior of individuals, e.g. planning for retirement, but also the short-term saving behavior of individuals, e.g. if people account for emergency expenses, etc. The implications that are product of this research will relate to issues of financial behavior, welfare loss and inevitably financial education, thus contributing to the existing literature and highlighting once more the importance of sound financial education for citizens, as this has important consequences for the welfare position of these individuals and the stability thereof.

This thesis paper will be organized as follows: Chapter 2 will review the existing literature on financial literacy in relation to wealth, whereas Chapter 3 will introduce the data as well as highlight parts of the analysis. Chapter 4 will discuss implications, conclusions and further recommendations. Chapter 5 constitutes of the modules, further appendices and references.

2. Literature review

The topic of financial literacy has heretofore received no small attention, especially of late, most likely because of the financial system mishaps and restructuring. In understanding what the core of the research previously done has been, Hogarth (2002) defines the concept of financial literacy as follows: ‘understanding of basic concepts underlying the management of money and assets and being knowledgeable, educated and informed on the issue of managing money and assets.’

Both the OECD (2005) and Lusardi & Mitchell (2007b) have done work on the phenomenon of financial literacy and both studies have shown that illiteracy in this case is not only very real, but very widespread as well. Another outcome of these works was that illiteracy is more prevalent among the elderly, the young and women, thus suggesting that improving the comprehension of financial components might require a specifically tailored approach for all sub-divisions. Not only do these studies show a lack of financial knowledge within the US, but also in several European countries as well as in Asian countries, in essence demonstrating that financial illiteracy is a worldwide problem and not just bound to First-world countries or specific cultures.

Financial behavior displayed by individuals is strongly influenced by financial illiteracy. Stango and Zinman (2007) have pointed out that financial illiteracy determines to a great deal the borrowing conduct of individuals, insinuating that people with low understanding of basic concepts such as interest rates borrow at relatively higher costs. This has been corroborated by Moore (2003), saying this might have implications for individuals taking out mortgages on property with higher rates or less favorable structures, making the investment less profitable. The origin of the loss would thus be contributed to the unsophisticated house owner. Agarwal, Driscoll, Gabaix and Laibson (2009) have provided further evidence for this, whilst also illustrating that financial misconceptions exist for other financial products.

Earlier research conducted has also provided insight regarding the implications of retirement planning and financial literacy. Lusardi and Mitchell (2011) have concluded that accurately planning, and succeeding in such, for retirement is partly influenced by the level of financial sophistication. This, in turn, affects the level of wealth individuals are left with after retirement. Further culminations were that people often did not at all account for retirement plans or did so by making use of crude rules of thumb, which has also been noted by Chan and Stevens (2008) in a different way. They pointed out that savings and pension decisions were more than often influenced by flawed thinking and erroneous information. One might argue that in the Netherlands the discussion concerning retirement planning is to a certain extent redundant, as the pension system is arranged in such a way that people are automatically involved in pension plans if being employed and mandatory contributions are not exceptional. However, this does not account for self-employed individuals as well as the pension surplus which people have to account for themselves, which is increasingly becoming an issue because of reorganizations throughout and liberalization of the system.

Not only the elderly have to cope with financial decisions as Lusardi, Mitchell and Curto (2009) make clear; young adults face similar problems regarding college loans and future expenses. Young people have stated that anxiety and insecurity arise when discussing diverse financial matters and have commented that they themselves are in need of financial education. It is highlighted that financial education is of the utmost importance as these young adults will be confronted with complex decisions in an elaborate environment whilst doing so with a disturbingly low set of financial skills.

Several studies have been undertaken to determine the effect of financial literacy on people’s financial state of affairs. To be more specific, researchers have already devised certain modules as to assess the level of financial literacy of people and variables related to the process of decision-making with regards to financial matters. Before inventing measurements of financial literacy, proxies were deemed to be sufficient by Calvet, Campbell and Sodini (2007) and Vissing-Jorgenson (2004) before that. As is explained by Lusardi, van Rooij and Alessie (2011), the main issue with the proxy variables would be that the effect of the proxy variable is hard to separate from the effect of the independent variable intended to measure.

Lusardi et al.(2007) conducted surveys amongst Dutch households and utilized questions they created for the sole purpose of measuring basic and advanced financial literacy, in order to make a comprehensive index of the level of financial literacy. This division in the assessment of financial literacy is interesting as this allows the researcher to possibly make inferences with regards to the two indices separately. These questions proved to measure financial literacy accurately, although it was indicated that individuals were highly sensitive to the wording of the questions. However, it was shown that this is not of the utmost importance for the results, as these did not change significantly whilst subjecting the questions to change or exclusion of certain elements. The particular research of Lusardi et al. (2007) has shown that stock market participation and financial literacy among individuals are positively correlated and that illiteracy deters people from reaching their most optimal point in terms of welfare analysis. Other implications include the fact that financial education might require strong revision and more attention than it deserves up until now.

Complementary to the former study, the study of van Rooij, Alessie and Lusardi (2011) revolves around the correlation between financial literacy, retirement planning and household wealth. The focus of the research lies with retirement planning and participating in the stock market, whereas other investment opportunities, general saving and attitude towards saving play side roles. In this study they have made use of the exact same module as has been mentioned before and the research has been conducted in the Netherlands as well. The research has proven that financial literacy is indeed positively correlated with household wealth and the financially more literate are prone to plan more effectively for their retirement. This research proved that financial literacy is an important indicator of the fact that individuals are subject to welfare loss, due to the fact that they are not capable enough to seize the opportunities to improve their welfare state.

It has also been mentioned that the financially more literate would invest in stocks more frequently or would be more willing to do so, because of the fact that less psychological thresholds exist and because of the information costs, which are more abundant with the less literate.

Gustman, Steinmeier and Tabatabai (2010) have commented that the relation of cause and effect between pension wealth and knowledge thereof might however be different than is being often portrayed. They question whether it might not be the case that pension wealth influences knowledge thereof, instead of vice versa. It would make sense, as people with more wealth to lose or to invest for that matter would seek to keep or increase it.

Focusing on the module utilized by Lusardi et al. (2011), it could however be argued that the module utilized is somewhat generalized and falls short of some aspects of financial knowledge or capability related to the scope of the research. No questions are included regarding knowledge of pensions or mortgages, whilst the research attempts to make inferences on literacy and household wealth, the latter of which is comprised of such elements. Several questions that were posed to assess the carefulness of an individual as an extension, might be perceived as being somewhat ambiguous, whereas others might be considered leading and/or including errors of social desirability. Managing money is comprised of more elements than is accounted for by the module.

Another study, conducted by Bertrand and Morse (2011), directs the attention to another point, namely that of people which deliberately make decisions whilst not fully aware of the negative consequences or exact gain. In essence this refers to people that are ill-informed and prey to savvy business models including subprime products which do not improve their financial position given the alternatives, but rather take advantage of the intellectual deficiencies of those individuals and worsen their financial position. More importantly, this study made a valid point arguing that people do indeed learn when being provided with information related to the issue, meaning that people which were made aware of some biases or informational asymmetries, thus improving their financial capacity, some of these participants were improving upon their initial state. According to Bertrand, people are thus capable of learning and improving upon their financial literacy. Bertrand also commented on the need for financial education by saying that the costs might be too high for the risk-group and the needed guidance would not reach those most in need of it.

The research that will be conducted will not attempt to make inferences regarding financial education or specific types of financial behavior, but rather investigate whether financial literacy is to be connected to household wealth, whilst holding in regard the features which might additionally influence wealth on a different level, not unlike tendency to save and self-awareness of financial illiteracy or lack thereof.