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Financial Literacy, Retirement Planning, and Household Wealth
01 Aug 2011-Research Papers in Economics (Center for Research on Pensions and Welfare Policies, Turin (Italy))-
TL;DR: This paper investigated the relationship between financial literacy and household net worth, relying on comprehensive measures of financial knowledge designed for a special module of the DNB (De Nederlandsche Bank) Household Survey.
Abstract: There is ample empirical evidence documenting widespread financial illiteracy and limited pension knowledge At the same time, the distribution of wealth is widely dispersed and many workers arrive on the verge of retirement with few or no personal assets In this paper, we investigate the relationship between financial literacy and household net worth, relying on comprehensive measures of financial knowledge designed for a special module of the DNB (De Nederlandsche Bank) Household Survey Our findings provide evidence of a strong positive association between financial literacy and net worth, even after controlling for many determinants of wealth Moreover, we discuss two channels through which financial literacy might facilitate wealth accumulation First, financial knowledge increases the likelihood of investing in the stock market, allowing individuals to benefit from the equity premium Second, financial literacy is positively related to retirement planning, and the development of a savings plan has been shown to boost wealth Overall, financial literacy, both directly and indirectly, is found to have a strong link to household wealth
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TL;DR: An assessment of a rapidly growing body of economic research on financial literacy and thoughts on what remains to be learned if researchers are to better inform theoretical and empirical models as well as public policy are offered.
Abstract: This paper undertakes an assessment of a rapidly growing body of economic research on financial literacy. We start with an overview of theoretical research which casts financial knowledge as a form of investment in human capital. Endogenizing financial knowledge has important implications for welfare as well as policies intended to enhance levels of financial knowledge in the larger population. Next, we draw on recent surveys to establish how much (or how little) people know and identify the least financially savvy population subgroups. This is followed by an examination of the impact of financial literacy on economic decision-making in the United States and elsewhere. While the literature is still young, conclusions may be drawn about the effects and consequences of financial illiteracy and what works to remedy these gaps. A final section offers thoughts on what remains to be learned if researchers are to better inform theoretical and empirical models as well as public policy.
2,176 citations
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TL;DR: A meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies finds that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples.
Abstract: Policy makers have embraced financial education as a necessary antidote to the increasing complexity of consumers’ financial decisions over the last generation. We conduct a meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies. We find that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples. Like other education, financial education decays over time; even large interventions with many hours of instruction have negligible effects on behavior 20 months or more from the time of intervention. Correlational studies that measure financial literacy find stronger associations with financial behaviors. We conduct three empirical studies and we find that the partial effects of financial literacy diminish dramatically when one controls for psychological traits that have been omitted in prior research or when one uses an instrument for financial literacy to control for omitted variables. Financial education as studied to date has serious limitations that have been masked by the apparently larger effects in correlational studies. We envisage a reduced role for financial education that is not elaborated or acted upon soon afterward. We suggest a real but narrower role for “just in time” financial education tied to specific behaviors it intends to help. We conclude with a discussion of the characteristics of behaviors that might affect the policy maker’s mix of financial education, choice architecture, and regulation as tools to help consumer financial behavior.
835 citations
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TL;DR: In this article, the authors review the literature on financial literacy, financial education, and consumer financial outcomes, and examine how well the existing literature addresses whether financial education improves financial literacy or personal financial outcomes.
Abstract: In this article we review the literature on financial literacy, financial education, and consumer financial outcomes. We consider how financial literacy is measured in the current literature, and examine how well the existing literature addresses whether financial education improves financial literacy or personal financial outcomes. We discuss the extent to which a competitive market provides incentives for firms to educate consumers or offer products that facilitate informed choice. We review the literature on alternative policies to improve financial outcomes, and compare the evidence to evidence on the efficacy and cost of financial education. Finally, we discuss directions for future research.
556 citations
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TL;DR: The authors analyzes the decisions of a hyperbolic consumer who has access to an imperfect commitment technology: an illiquid asset whose sale must be initiated one period before the sale proceeds are received.
Abstract: Hyperbolic discount functions induce dynamically inconsistent preferences, implying a motive for consumers to constrain their own future choices. This paper analyzes the decisions of a hyperbolic consumer who has access to an imperfect commitment technology: an illiquid asset whose sale must be initiated one period before the sale proceeds are received. The model predicts that consumption tracks income, and the model explains why consumers have asset-specific marginal propensities to consume. The model suggests that financial innovation may have caused the ongoing decline in U. S. savings rates, since financial innovation in- creases liquidity, eliminating commitment opportunities. Finally, the model implies that financial market innovation may reduce welfare by providing âtoo muchâ liquidity.
5,587 citations
"Financial Literacy, Retirement Plan..." refers background in this paper
...…longevity and bequests (Hurd, 1989), different economic opportunities across cohorts (Kapteyn, Alessie and Lusardi, 2005), self-control problems (Laibson, 1997; Benartzi and Thaler, 2004; Ameriks, Caplin, Leahy and Tyler, 2007), unexpected events (Venti and Wise, 2000; Lusardi, 2003), and…...
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..., 2005), self-control problems (Laibson, 1997), unexpected events (Venti and Wise, 1998) and health (Rosen and Wu, 2004)....
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TL;DR: For example, this paper found that men trade 45 percent more than women and earn annual risk-adjusted net returns that are 1.4 percent less than those earned by women, while women perform worse than men.
Abstract: Theoretical models of financial markets built on the assumption that some investors are overconfident yield one central prediction: overconfident investors will trade too much. We test this prediction by partitioning investors on the basis of a variable that provides a natural proxy for overconfidence--gender. Psychological research has established that men are more prone to overconfidence than women. Thus, models of investor overconfidence predict that men will trade more and perform worse than women. Using account data for over 35,000 households from a large discount brokerage firm, we analyze the common stock investments of men and women from February 1991 through January 1997. Consistent with the predictions of the overconfidence models, we document that men trade 45 percent more than women and earn annual risk-adjusted net returns that are 1.4 percent less than those earned by women. These differences are more pronounced between single men and single women; single men trade 67 percent more than single women and earn annual risk-adjusted net returns that are 2.3 percent less than those earned by single women.
3,803 citations
"Financial Literacy, Retirement Plan..." refers background in this paper
...Barber and Odean (2000, 2001), for instance, provide evidence of overconfident investors trading excessively and ending up with lower returns on their investments....
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TL;DR: In this paper, the authors argue that overconfidence can explain high trading levels and the resulting poor performance of individual investors, and that trading is hazardous to the wealth of individuals who hold common stocks directly.
Abstract: Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that traded most earned an annual return of 11.4 percent, while the market returned 17.9 percent. The average household earned an annual return of 16.4 percent, tilted its common stock investment toward high-beta, small, value stocks, and turned over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.
2,543 citations
Posted Content•
TL;DR: In this article, the authors report on direct measures of preference parameters relating to risk tolerance, time preference, and intertemporal substitution, based on survey respondents' choices in hypothetical situations.
Abstract: Individuals' preferences underlying most economic behavior are likely to display substantial heterogeneity. This paper reports on direct measures of preference parameters relating to risk tolerance, time preference, and intertemporal substitution. These experimental measures are based on survey respondents' choices in hypothetical situations. The questions are constructed with as little departure from the theorist's concept of the underlying parameter as possible. The individual measures of preference parameters display substantial heterogeneity. The majority of respondents fall into the least risk-tolerant group, but a substantial minority display higher risk tolerance. The individual measures of intertemporal substitution and time preference also display substantial heterogeneity. The mean risk tolerance is 0.25; the mean elasticity of intertemporal substitution is 0.2. Estimated risk tolerance and the elasticity of intertemporal substitution are essentially uncorrelated across individuals. Because the risk tolerance measure is obtained as part of the main questionnaire of a large survey, it can be related to a number of economic behaviors. Measured risk tolerance is positively related to a number of risky behaviors, including smoking, drinking, failing to have insurance, and holding stocks rather than Treasury bills. Although measured risk tolerance explains only a small fraction of the variation of the studied behaviors, these estimates provide evidence about the validity and usefulness of the measures of preference parameters.
1,855 citations
TL;DR: In this article, the authors evaluated 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, they make use of questions measuring financial knowledge before investing in the stock markets.
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.
1,834 citations