Financial Literacy: “and” not “or”

“Everyone is entitled to his own opinion, but not his own facts” – Daniel Moynihan

@GregBDavies points me to this article by J.D. Roth. First, let me say I agree with many things in it. Knowledge is not enough, you have to take action, sometimes use of behavioral finance is the most effective way etc..

However, like I state previously, the fait-accompli conclusions that financial literacy doesn’t work is completely unsupported. Strong opinions without facts to back them up are things we should be wary of. To my knowledge most independent evidence points to positive effects of financial literacy programs.

I already touched on how financial literacy interacts with basic financial management, but it also effects investing behavior. Here is van Rooij, Lusardi, and Alessi in the Journal of Financial Economics:

The empirical estimates in Table 7 show that financial literacy matters for stock ownership, even after controlling for a large set of demographic characteristics and income and wealth. Those who display higher literacy are more likely to participate in the stock market. The estimates are also sizable: A one-standard deviation increase in advanced literacy raises stock market participation by more than 8 percentage points. Note that the effect is as large as the effect of formal education and wealth. For example, having a university degree increases stock market participation by more than 9 percentage points. Compared to the first quartile of wealth (values up to 2,300 Euros), having wealth in the second quartile (up to 45,000 Euros) increases stock market participation by more than 7 percentage points. Note also that when we account for basic literacy the estimate of advanced literacy does not change. The estimates in Table 7 indicate that financial literacy affects stock market participation above and beyond the effect of the traditional determinants of stock ownership.

When we devised the module on financial literacy, we took into account the fact that financial literacy is not an exogenous characteristic; in fact, literacy can itself be affected by financial behavior (for example, if individuals learn via experience). To remedy this problem, we have collected additional information (beyond current levels of economic knowledge) that can serve as instruments for advanced financial literacy. To be able to rely on measures of
literacy that are exogenous with respect to stock market participation, we asked respondents about their exposure to financial knowledge before entering the job market. Specifically, we asked how much of their education was devoted to economics. 14 Note that economics is part of the high school curriculum at the majority of schools in the Netherlands and it is possible to specialize in economics/business at the high school level (economics degrees can be pursued in college as well, of course).15 Our strategy is to rely on exposure to economic education in the early stages of life. This measure should be correlated with current advanced knowledge while it should be uncorrelated with stock market participation. As mentioned before, advanced knowledge may be a crude proxy of actual knowledge. Moreover, it may simply reflect how much respondents have learned from their personal  experiences and from their success in the stock market. For example, if financially knowledgeable respondents are more likely to invest successfully and stay in the market, while low knowledge respondents are more likely to lose money and exit the market, the relationship between literacy and market
participations may simply reflect the higher knowledge of those who stay in the market.

The first stage regressions are reported in Table 8. Responses to how much of education was devoted to economics range from “hardly at all” to “a lot” and we construct dummies for different levels of economics education while in school. These instruments have a strong predictive power: Those who have had less exposure to economics education in school are less likely to display advanced knowledge, and this holds true even when we account for basic literacy, which we consider a measure of cognition and ability. The Fstatistic in the first stage regressions is high (with values close to 20) and beyond the values recommended to avoid the weak instruments problem (Staiger and Stock (1997) and Bound, Jaeger and Baker (1995)). The first stage results also continue to confirm the correlation between literacy and demographic characteristics, such as education and gender, reported in Table 4B. The estimates in the second stage reported in the last two columns of Table 7 show that the relationship between literacy and stock market participation remains positive, statistically significant, and is even larger in the Generalized Method of Moments (GMM) estimates. Moreover, the exogeneity test is not rejected. Thus, the OLS estimates do not differ significantly from the GMM estimates. The results of the Hansen J-test show that the overidentifying restrictions are not rejected. Overall, our estimates indicate that financial literacy is an important determinant of stock market participation: Those who have low financial knowledge are less likely to hold stocks.

Financial literacy doesn’t make you into George Soros, sure, but it does improve your debt management, savings behavior, and propensity to invest in stocks.

The core problem seems to be the all-or-nothing assessment. It seems expected that financial literacy acts like a vaccine, and once educated, you are inoculated for life, and you’ll be a perfect trader. Against that impossible standard, programs definitely fall down. But it’s not a vaccine, it’s like most skills you learn – you need to keep using/practicing them to keep your skills up over time. And there are real returns to using it.

And indeed, a combination of being financially literate and using the successes in behavioral finance are most likely to get from where you are to where you want to be. It’s not “or”, it’s “and”.


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