People with insufficient financial know-how do not invest enough in stock markets. What sounds like a bad joke, given stock market events over the last two years or so, is actually a serious and relatively well-researched hypothesis on the effectiveness of economic education. Over the long term, the higher risks connected with shares should – according to the economic rule of thumb – be rewarded by higher returns than those on a bank account. It is well known that educated and affluent households are more likely to invest part of their wealth in shares.[1] If the rule of thumb cited above holds true, then this would make the gap between richer and poorer households even greater.

A study in the Netherlands suggests an additional role for financial know-how: people who are better at answering financial literacy questions invest more often in shares than other people with comparable wealth and an otherwise similar level of education. Using various estimation methods, the authors conclude that knowledge tends to drive investment, rather than vice versa.[2]

As already indicated, however, the studied education effect should be viewed critically. People who avoid shares do not make any obvious mistakes, since shares carry an inherent risk (large price movements). The hoped-for return is not guaranteed ...

The above chart is indeed a source of frustration for all 'rule-of-thumb disciples', and a gift to sceptics: between May 2007 and March 2009, the SPI (an index for exchange-traded Swiss shares) fell by more than 45%. This speaks for itself. Unless of course – and this is the drawback of charts like this, which can be manipulated – you select a different time period. Over a twenty-year time span, the chart looks like this (the time span from the previous chart is framed in red):

Despite a financial crisis of historic proportions, this share index has undergone a fourfold increase in the last twenty years. That corresponds to an annual return of over 7%. It seems economists have been lucky once again: the rule of thumb isn’t that ridiculous after all, at least not when investments are made cautiously and gradually and over a very long period of time.

There is another rule which is less disputed: when investing in shares, broad diversification can result in the same returns, yet at a lower risk. A study carried out in Sweden investigated how well people diversify.[1] It appears that households there suffer on average few losses as a result of poor diversification. Interestingly, a minority – a less well-educated one – could have yielded considerably better results thanks to diversification. The study did not look into the degree to which economic literacy had a role to play.

On behalf of the iconomix team

Michael Manz

[1] Cf. Campell, J. (2006), Household Finance, The Journal of Finance, 61, pp. 1553–1604.

[2] Cf. Lusardi, A., M. van Rooij and R. Alessie (2007), Financial Literacy and Stock Market Participation, NBER Working Paper 13565.