Lack Of Financial Literacy Is One Of The Main Reasons Which Cause Limited Participation In The Stock Market

Abstract

The following paper provides in-depth examination of underlying factors which affect low stock market participation rate among households. Clearly, advices based on the world-known assumptions and modern portfolio theory are not being followed by individual investors. Despite the significant risk premium, half of the American households do not own the stocks due to various reasons starting from risk aversion and ending with macroeconomic factors. However, some researchers point out lack of financial literacy as one of the main reasons which cause limited participation in the stock market. In the 21st century when budgeting is an important part of every household, the value of financial literacy is undeniable. The following paper, backed by many researches and analyzes, indicates that financial literacy correlates with household participation in the stock market.

Keywords: stock market, financial literacy, household, limited participation, reasons.

Introduction

A lot of academicians have devoted their time and effort analyzing stock market as well as the factors which affect the participants. Despite the logical belief that all investors are participating in the stock market when expected returns are positive, the tendency of factual data is evident that some are not investing neither directly or indirectly. Looking into reasons which are holding a lot of people back from stock market participation and pointing them out is essential for both households and governments. Among the investors it is generally known that because of the compound interest, individuals who are participating in the stock market can generate more money compared to those who choose not to. According to Hardy (2010), there was an experiment where many random people were asked if they would rather have a million dollars now or take a penny today and double it for the next 30 days.

As expected, majority took 1 million now, but when the actual calculations are made, those people who chose a penny, at the end of the period would have over 5 million dollars. Though 100% return is very unlikely, but the idea of compound effect works even for much lower interest rates, it just might take longer than a month to make millions. This means that the wise investment of little bit of money can compound into a fortune. Albert Einstein used to call compound interest one of the greatest mathematical concepts and even compared it to the 8th wonder of the world. On the other hand, while there are a lot of stocks which are booming with high expected returns, poor allocation of capital and lack of knowledge might lead to financial distress. To take this a step further, this paper is a summary of variables that affect household participation in the stock market and its relation to financial literacy. 

Data

Household participation in the stock market has been a hot topic of many academic researchers in the personal finance over the last years. The tendency is evident that most of the households shy away and do not invest in the stocks even though it offers a significant risk premium. Based on S&P 500 stock market index, the average total annual return including dividends on investments in the last decade was 10.38% (“S&P 500 Index”, n.d.). Despite 2008, when financial crisis took place, the returns of every single year were positive. However, investment class is narrow, and it is not getting bigger since the great depression of 2008.

In addition, people became more suspicious about putting their money to work and shifted from higher risk investments (stocks) to savings accounts. Even now, ten years after financial crisis, households still have not changed their attitude towards capital market. According to Jones (2017), only 54% of American households own stocks, compared with the pre-crisis level of 62%. Also, a lot of them hold just a small amount of stocks. Research, conducted by Wolff (2016), uncovered that 84% of all stocks owned by Americans are concentrated in the hands of the top 10% wealthiest households.

These statistics include direct ownership of the stocks as well as indirect through mutual funds and other accounts. Similar survey was done by Jones (2017) which revealed percentage rates of investors in terms of annual income.

2001-2008 2009-2017

U.S adults 62% 54%

Annual household income:

Less than $30,000 27% 21%

$30,000 to $74,999 67% 54%

$75,000 to $99,999 85% 75%

$100,000+ 88% 89%

From the table the trend is clear that ownership rates have deteriorated in the past years and correlate with the income level. Even though in the last couple of years stock market performed well, it is obvious that fewer households are willing to take risk in order to benefit from today’s bulls market compared to pre-crisis conditions.

Another study was conducted to test the knowledge of market participants (Rooij, Lusardi & Alessie, 2007). The researchers prepared questionnaires regarding the financial markets and asked 1,508 households to fill out the module (a total of 1,373 households completed the survey). The results showed the tendency that many individuals are not educated enough to compete in the stock market and to benefit from investing. For example, only 67% out of all households were able to define stock market and its purpose.

Overall, based on S&P index and various studies, stock market has an enormous potential and could generate a fortune to anybody in case of well allocated capital. Yet, only the very rich are enjoying full benefits of the compound effect. Financial crisis of 2008 only complicated everything and the gap between the rich and the poor increased. It is evident that households fear to put their money into something they do not understand completely.

Markowitz portfolio theory

On the other hand, empirical findings contradict the Markowitz portfolio theory which asserts that in order to maximize the utility, individuals must create a diversified portfolio of unrelated assets. The theory implies that capital allocation among various financial instruments balances returns and risks of the investors, “unless they are infinitely risk averse and/or expected equity risk premium is not present in the market” (Mauricas, Darškuvienė & Mariničevaitė, 2017, p. 228). In the other words, if investors combine asset classes that fluctuate each individually, the volatility of the entire portfolio should be low. Because of diversification, the entire portfolio is much more stable and can sustain even dramatic fluctuations. For example, gold may plunge by 20% in a year, while oil boom by 25%.

In this scenario, even though gold has suffered an extreme loss, the entire value of the portfolio has risen due to diversification. It is directly associated with the traditional wisdom of “never putting all your eggs in one basket”. In addition, as quoted by Haliassos and Hassapis (2002): “A marginal addition of stocks should be preferred to a marginal addition of the riskless asset by someone that holds no stocks”. But nowadays people face trade-off between familiarity and diversification. The empirical data shows that people feel more confident investing in riskless assets rather than in stocks. Further paragraphs explain the main reasons why reality differs from the theory of utility maximization and why households are so anxious towards buying stocks.

Factors which influence households

Even though, according to the evidence, long-term investments in stock market earn positive returns and investors do not have irrationally large level of risk aversion, yet, households underestimate equity market. On the other hand, there are many other factors which affect investment decisions in the stock market both positively and negatively.

Firstly, Lee, Rosenthal, Veld and Merkoulova (2013) investigated stock market expectations and risk aversion of households based on the Dutch National Bank Household Survey. Just as the researchers predicted, expectation of high returns increased stock participation, while high risk aversion – decreased.

Next important determinant which causes market participation puzzle is the overall wealth of the households. The Eurosystem survey completed in 2016 point out that income have a considerable effect on stock participation as well. Also, activeness in equity market increases with age, “with 16–34-year-olds having twice lower stock market participation compared to 45–74-year-olds” (Mauricas et al., 2017, p. 229). However, it is generally known that older people are usually wealthier, even though age as an indicator was found to be irrelevant.

Fraile and Ehrmann (2014) researched household eagerness to invest in stock market and how it is affiliated to overall macroenvironment. The authors found out that individual’s willingness to take additional risks to invest in stocks was positively related to an overall macroenvironment. For instance, the period of bull market encouraged households to participate in the stock market, while the recession – reduced the desire of putting money to work.

Another category of researches was conducted to find the relation between the stock market participation puzzle and financial literacy. According to Heath and Tversky (1991), investors are more confident in financial decision making when they feel that they have all the information available. Logically, since investing in stock market requires rationality, Rooij et al. (2007) discovered a positive relationship between the financial literacy and equity market participation. Gaudecker (2013) extended the research on this topic and discovered that individuals who lack of financial literacy and awareness about “hot stocks” tend to “put all their eggs in one basket” what eventually leads to smaller returns in the long-run.

Finally, having services of financial consultant is valuable to households as well, because in this way professional advisors can substitute the lack of knowledge (Georgarakos & Inderst, 2014).

To sum up, there are a lot of factors that influence stock market participation either positively or negatively. Besides mentioned above it is worth to point out loss aversion (negative effect), fixed entry cost (negative effect), investments in real estate (negative effect), income inequality (negative effect), trust (positive effect), IQ of an investor (positive effect) and many others. Having reviewed the key factors which explain market participation puzzle, the paper aims to evaluate the importance of financial literacy.

Financial literacy

Another possible explanation of the puzzle why households do not participate in the stock market is the lack of knowledge about financial instruments. Shortage of financial literacy has been an issue in many countries, including well-developed and advanced societies. The opportunity cost of not having it in some cases might be substantial, because financial knowledge helps to make informed decisions and can create well-being for an individual (Muchiri, 2015). The importance of it takes place, for instance, when individuals are considering how to save for their pension, where to invest or how to ensure that they are able pay off a mortgage.

However, the supply of more complicated financial instruments is increasing, even though study conducted by Flash Eurobarometer in 2009 found out that 50% of EU citizens would like to be provided with simpler financial services. According to Remund (2010), the term financial literacy covers concepts ranging from financial awareness and knowledge, including of financial products, institutions and concepts; financial skills, such as the ability to calculate compound interest payments; and general knowledge in money management and personal finance. In the 21st century when budgeting plays an important role in everyone’s life, the need for financial literacy is undeniable.

Rooij et al. (2007) found out that majority of the people who lack financial knowledge and must make important financial decisions, approach their relatives and friends, while only around a quarter go to financial advisor or refer to financial magazines, guides or books. More and more governments are starting to appreciate the value of economic knowledge and are starting to invest their money and time in financial education programs (Gallery, Newton & Palm, 2010). For example, few academicians have proved that individuals who have a college degree are more likely to own stocks (Haliassos and Bertaunt, 1995; Campbell, 2006; Lusardi and Scheresberg, 2013). Prior studies have shown that the quality of financial literacy correlates with household participation in the stock market.

Conclusion

To sum up, the paper reveals that even though Markowitz portfolio theory and many other studies reasonably explains the advantages of having diversified portfolio, households are still anxious towards investing in the stock market. That is why it is of crucial importance to identify and underline the reasons which cause limited household participation in the stock market phenomenon. The paper finds quite a few factors which affect the public attitude towards investing such as expected returns, risks, macroenvironment, overall wealth of the household, financial advices and many other. However, one of the most important reason which holds many households back is the lack of financial literacy. It is logical that people do not want to invest into something they do not understand. Consequently, governments and financial institutions have a responsibility to allocate their assets and time towards building the necessity and value of financial literacy in every person through schools, universities and other educational institutions.