Dutch Study: Limited Financial Literacy Hurts Equity Participation

October 31, 2007 (PLANSPONSOR.com) - At a time when more of the burden of directing their retirement savings program is being placed on investors, some don't have the requisite financial literacy to best handle their new responsibilities.

That was a key conclusion of a Dutch study by three economists of the level of investors’ knowledge about investment vehicles and market dynamics and particularly the extent to which they put money into the equity markets. The paper, Financial Literacy and Stock Market Participation, was prepared for the National Bureau of Economic Research.

“Individuals have become increasingly active in financial markets and market participation has been accompanied or even promoted by the advent of new financial products and services,” the paper said. “However, some of these products are complex and difficult to grasp, especially for financially unsophisticated investors.”

Authors Maarten van Rooij, of the Dutch Central Bank; Rob Alessie of Utrecht University Department of Economics and Annamaria Lusardi, Department of Economics at Dartmouth College, found through their survey that those with low literacy are more likely to rely on family and friends as their main source of financial advice and are less likely to invest in stocks.

The researchers found financial literacy to be limited among their Dutch respondents when it came to understanding stocks and bonds, the concept of risk diversification, and the working of financial markets.

“Our data show that the majority of households display basic financial knowledge and have some grasp of concepts such as interest compounding, inflation, and the time value of money,” the authors wrote. “However, very few go beyond these basic concepts; many households do not know the difference between bonds and stocks, the relationship between bond prices and interest rates, and the basics of risk diversification.”

In fact, the paper suggested that a lack of understanding of economics and finance is a “significant deterrent” to stock ownership. In response, properly targeted financial education efforts may be key to helping workers more effectively save for retirement, the economists contended.

“…financial literacy differs substantially depending on education, age and gender. This suggests that financial education programs are likely to be more effective when targeted to specific groups of the population,” the authors asserted. “… any privatization programs should take into account that, when put in charge of investing for their retirement, financially unsophisticated individuals may not invest in the stock market. Thus, to work effectively, privatization programs need to be accompanied by well-designed financial education programs.”

The research report can be ordered from http://www.nber.org/papers/w13565 .