Swedroe: The Dangerous Educational Gap

September 26, 2016

A large body of research on the behavior of individual investors has demonstrated that low levels of financial knowledge, in addition to biases in the selection and processing of information, drive suboptimal financial choices.

Among the findings from the literature are:

  • Men tend to be more financially literate than women, independent of country of residence, marital status, educational level, age, income and their possible role as decision-makers.
  • Women tend to be less confident than men, though they are more aware of their own limits. This is a positive finding, because overconfidence, which may lead to excessive risk taking, excessive trading and lack of diversification, is negatively related to performance. The result is that women outperform men. Note that it has been found that higher levels of education may lead to higher levels of overconfidence. (Any financial advisor who has worked with doctors would confirm this!)
  • Degree of financial knowledge tends to be positively correlated with education and wealth.
  • Individuals with a high degree of financial literacy tend to exhibit a higher risk tolerance and a higher degree of patience, as well as greater willingness to spend time acquiring financial knowledge.
  • Financial experience, as measured through the ownership of financial instruments and the holding period length of risky assets, is positively associated with financial knowledge.
  • Regret aversion (coupled with low literacy) may deter the demand for professional help if individuals anticipate the possibility that advisors will highlight mistakes in their previous decisions.

Monica Gentile, Nadia Linciano and Paola Soccorso contribute to the literature on investor education and behavior with their March 2016 working paper, “Financial Advice Seeking, Financial Knowledge and Overconfidence: Evidence from the Italian Market.”

The authors write: “The effectiveness of both investor education and financial advice may be challenged by individuals’ behaviours and reactions. Unbiased financial advice can substitute for financial competence only if unsophisticated investors seek the support of professional advisors. Furthermore, advice may not reach overconfident investors deciding on their own on the basis of self-assessed rather than actual capability. Conventional financial education initiatives may exacerbate overconfidence and/or other biases distorting further investors’ decision-making process.”

Drawing on data from more than 1,000 Italian households, the authors analyzed the relationship between investors’ propensity to seek professional investment advice, financial knowledge and self-confidence, as well as the determinants of financial knowledge and self-confidence.

Following is a summary of their findings:

  • The majority of individuals exhibited a very low degree of financial literacy. For example, almost half of respondents weren’t able to describe inflation, 55% incorrectly defined risk diversification, 57% did not correctly define the risk/return relationship, 72% were not able to compare investment options across expected returns and 67% showed insufficient understanding of simple interest rates.
  • Nearly 45% of investors preferred informal advice (that is, consulting relatives, friends and colleagues) to professional advice.
  • The authors, in general, found a lower level of financial knowledge among women, resulting in a gender gap.
  • Loss aversion was quite widespread. Overall, 55% of respondents weren’t willing to take financial risk, implying a chance of loss and 17% would disinvest after even a very little loss. However, financial knowledge is positively related to risk aversion. The more financial knowledge someone has, the less risk averse that investor tends to be.
  • Financial literacy positively affected financial advice seeking. The higher the level of financial literacy, the more likely it is that professional advice will be sought.
  • Financial knowledge was negatively related to high levels of investor self-confidence. Less knowledgeable investors were more confident of their skill (skill they do not, in fact, have). Overconfidence, in turn, discourages demand for advice (by the very people who need it the most).
  • Overconfidence was prevalent. For example, among individuals reporting an understanding of basic financial products equal or higher than the average person, 30% weren’t able to correctly define inflation and 44% couldn’t solve a simple-interest problem.
  • Financial advice acts as a complement rather than as a substitute of financial capabilities.

Gentile, Linciano and Soccorso concluded that their results confirm “concerns about regulation of financial advice being not enough to protect investors who need it most.”

They continue: “Additionally, our findings suggest that investor education programmes may be beneficial not only directly, i.e. by raising financial capabilities, but also indirectly, i.e. by enhancing people’s awareness of their financial capability and by hindering overconfident behaviours and behavioural biases. This latter outcome mitigates the worries about financial education fueling confidence without improving competence, thus leading to worse decisions.”

Summary

One of the great tragedies is that most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This remains true unless you attend an undergraduate business school or pursue an MBA in finance. Without a basic understanding of finance and markets, there’s simply no way for investors to make prudent decisions.

Making matters worse is that far too many investors think they know how markets work, when the reality is quite different. As humorist Josh Billings noted: “It ain’t what a man don’t know as makes him a fool, but what he does know as ain’t so.”

The result is that individuals make investments without the basic knowledge required to understand the implications of their decisions. It’s as if they took a trip to a place they have never been with neither a road map nor directions. Lacking formal education in finance, most investors make decisions based on accepted conventional wisdom—ideas that have become so ingrained that few individuals question them.

And some spend far more time watching reality TV shows than they do investing in their own financial literacy. Given the important role that financial literacy plays in achieving financial goals, this is dangerous behavior.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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