Swedroe: Financial Illiteracy’s High Cost

June 04, 2018

  • Financial literacy correlated with demographic variables; in particular, education and wealth.
  • Financial literacy was negatively correlated with being female—a gender gap that had been observed in prior studies.
  • An additional unit of financial literacy was associated with a 3.5% increase in the probability of holding stocks.
  • More literate households experienced higher portfolio returns.
  • Controlling for various measures of portfolio risk, the most literate households experienced yearly returns approximately 0.5% higher than the least literate households, relative to an average return of 4.2%. These magnitudes were in line with those found in a recent study of Dutch households.
  • There was no evidence that, overall, households with higher financial literacy choose riskier portfolios. Instead, their risk exposure varies systematically with market conditions, allocating more to risky assets when they have higher expected returns. A 1% increase in the expected excess return of risky funds was associated with a 2% increase in the risky share for each unit of financial literacy.
  • Decomposing the observed changes in the risky share over time into active changes due to portfolio rebalancing and passive changes induced by differential returns to risky versus riskless funds, Bianchi found that passive changes were relatively more important for less sophisticated households. For the least sophisticated households, passive changes accounted for 64% of the total change in the risky share over 12 months. For the most sophisticated households, by contrast, passive changes accounted for 30%. This demonstrates that households with lower financial literacy display greater portfolio inertia. More educated, older and female investors display lower levels of inertia.
  • More literate households were more likely to act as contrarians. Rebalancing, they tended to move their wealth toward funds that had experienced relatively lower returns in the past.
  • The returns more sophisticated households actually experienced tended to exceed the returns they would have earned without rebalancing their portfolios. More sophisticated households were more likely to buy funds that provided higher returns than the funds they sold.

Conclusion

Findings such as these demonstrate that financial illiteracy is costly. The fact that our educational system has failed to provide much of the public with what I would consider even a basic level of financial literacy certainly is a tragedy. (The research shows this is not a U.S.-only problem.) But perhaps the bigger tragedy is that so many apparently would rather watch some reality TV show than “invest” the time and effort to become financially literate.

I have now authored or co-authored 16 books on investing, presenting the evidence from academic research. This has been my way of trying to reduce financial illiteracy and help prevent investors from being sheared by the wolves of Wall Street. Others, such as John Bogle and William Bernstein, have written outstanding books on the principles of prudent investing.

The only problem is that the sales of Harlequin romance novels (not that there is anything wrong with them) are far greater than the sales of books on modern portfolio theory and efficient markets, providing one explanation for why investors continue to use nonfiduciaries as their advisors and adopt active management strategies—strategies with a high likelihood of failure.

The bottom line is that the greatest investment you can make, and the one with the highest expected return, is an investment in your own financial literacy. Remember, if you think the price of financial education is too high, just try the price of ignorance.

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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