Financial Illiteracy Damages your Wealth

Small differences in financial knowledge account for substantial differences in wealth, according to research by Maarten van Rooij and colleagues, published in the May 2012 issue of the Economic Journal.

Their study of a representative sample of Dutch people finds that only two in five can answer basic questions measuring their financial literacy – and this has a clear impact on their wealth. The net worth of an average financially ''sophisticated'' person is €80,000 more than an average financially ''unsophisticated'' person.

The researchers asked people five questions measuring their numeracy and knowledge of interest compounding, inflation, the time value of money and nominal versus real values. The results show that:

  • Financially literate individuals are 30 percentage points more likely to plan for retirement, increasing their wealth when older.
  • Financially literate individuals are 17 percentage points more likely to invest in the stock market. This offers the benefit of investing in high return assets and creates opportunities for risk diversification.
  • Having had an economics education when young is a strong predictor of financial knowledge in adulthood.

From a policy perspective, the benefits of greater financial sophistication are clear. Financial sophistication lowers the costs of collecting and processing information and reduces planning costs. This facilitates the execution of financial decisions and brings down economic and psychological thresholds for the development of retirement savings plans.

Financially knowledgeable consumers are better equipped to take responsibility for their financial wellbeing over the lifecycle. This reduces the chance of becoming dependent on public support when individuals run into financial problems or enter retirement without adequate retirement provisions.

An important question is what type of policy measures effectively stimulate and enhance financial sophistication. The finding about the value of economics education points to the important role of setting up education programmes to increase individual financial knowledge. At the same time, the lack of basic economic insights of a large group of consumers suggests that it is important to supplement financial education initiatives with other measures.

''Financial Literacy, Retirement Planning and Household Wealth'' by Maarten van Rooij, Annamaria Lusardi and Rob Alessie is published in the May 2012 issue of the Economic Journal.