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. However, some of these products are complex and difficult to grasp, especially for financially unsophisticated investors. At the same time, market liberalization and structural reforms in Social Security and pensions have caused an ongoing shift in decision power away from the government and employers toward private individuals. Thus, individuals have to assume more responsibility for their own financial well-being.
Are individuals well-equipped to make financial decisions? Do they possess adequate financial literacy and knowledge? There has been little research on this topic and the few existing studies indicate that financial illiteracy is widespread and individuals lack knowledge of even the most basic economic principles (Lusardi and Mitchell (2006, 2007a), National Council on Economic Education (NCEE, 2005), and Hilgert, Hogarth and Beverly (2003)). At the same time, there are concerns that households are not saving enough for retirement, are accumulating excessive debt, and are not taking advantage of financial innovation (Lusardi and Mitchell (2007b) and Campbell (2006)). The existing studies have also shown that those who are not financially literate are less likely to plan for retirement and to accumulate wealth (Lusardi and Mitchell (2006, 2007a)), and are more likely to take up high-interest mortgages (Moore (2003)).
To measure financial literacy and assess its relationship with financial decision making, we have devised two special modules for the DNB Household Survey (DHS), a panel data set covering a representative sample of the Dutch population and providing information on savings and portfolio choice. We have designed an extensive list of questions aimed at measuring and differentiating among different levels of literacy and financial sophistication. These questions can be linked to a rich set of data on demographic characteristics and wealth holdings. 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. 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. Most important, we find that financial literacy affects financial decision-making: 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.
This paper makes three contributions to the existing literature. First, we develop two indices of financial literacy and knowledge, which allow us to differentiate among different levels of financial sophistication. Adding this information to existing data sets can substantially enhance the studies on saving and portfolio choice. Second, we contribute to the methodology of measuring financial knowledge. There is a lot of noise in the responses to financial literacy questions and we show that the wording of the questions is critically important for measuring financial knowledge. Third, we provide a contribution toward solving the so-called “stock-holding” puzzle, i.e., the fact that many households do not hold stocks (Campbell (2006), Haliassos and Bertaut (1995)). We show that many families shy away from the stock market because they have little knowledge of stocks, the working of the stock market, and asset pricing. To address the direction of causality between literacy and stock market participation, we designed questions to measure not only current levels of literacy but also levels of literacy in the past. Moreover, we designed questions to measure cognitive ability in an attempt to disentangle the effects of knowledge from talents and skills.
Our findings have important policy implications. First, we show that financial literacy should not be taken for granted. A majority of households possesses limited financial literacy. Second, 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. Finally, 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.
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