scorecardresearchThis is how financial literacy can solve investment challenges for retail

This is how financial literacy can solve investment challenges for retail investors

Updated: 24 Sep 2022, 12:00 PM IST

Take financial education seriously and invest more in it! Basic financial education will help to increase financial participation.

Importance of financial literacy: Investment challenges by retail investors

Importance of financial literacy: Investment challenges by retail investors

Where do we stand with participation in financial markets? And, most importantly, where should we stand? In order to address these questions, we should first of all take into serious account the lessons that developed countries can share with us. Thanks to their leading position in terms of financial openness to retail investors, developed countries are an interesting leading indicator for countries like India.

In the US, slightly more than 50% of U.S. households own stocks. Participation in the stock market, however, varies considerably across demographic groups. According to pre-COVID surveys, among those with annual family incomes of less than $35,000 (i.e., an income below median), about 20% invest in the stock market. This share increases with income and it becomes as high as 88% among those with incomes above $100,000. The issue, however, is not about income. Rather it is about a more fundamental factor, namely, financial literacy.

According to a research article by Rooij, Lusardi and Alessie published in 2011 in the Journal of Financial Economics, participation in the US is crucially determined by financial literacy. That is, investors in the US with better knowledge of the differences between bonds and equities, bond prices and interest rates and basic concepts of diversification tend to invest more in the equity market.

In addition, prior work by Luisardi and co authors published in 2008 in the American Economic Review shows that financial illiteracy is widespread and particularly acute among specific groups of the population, such as women, the elderly, and those with low educational attainment.

These groups tend to have a less substantial presence in the financial markets. In countries like India, the issue of financial illiteracy becomes more pronounced when we compare urban versus rural population. Taken together, these findings justify more effort in financial literacy across many different groups of potential investors. 

The aforementioned results are not US-specific. If we turn our attention to the EU, we find similar results. According to the OECD/INFE 2020 international survey of adult financial literacy, about half of the EU adult population does not have a good enough understanding of basic financial concepts. The problem is more evident for low-income groups, women, young people, and older people.

In 2020, the European Commission reaffirmed that sound financial literacy is at the heart of people’s financial well-being. The Commission and the OECD are working together to develop joint ‘financial competence frameworks’ for adults and for children.

Across the globe, including India, there is consensus about the fact that everyone should be able to understand the risks involved when borrowing or investing money. Financial literacy can help individuals plan for the future, make better decisions about what to do with their money, and invest in capital markets in a way that meets their needs.

Access to appropriate financial literacy is a key factor in order to have more participation in financial markets. In addition, financial literacy is crucial to have more *educated/appropriate* access to markets. That is, financial literacy helps to have a higher participation by investors that know how financial markets should work.  

A neglected risk deserving more attention in the future concerns the potential increase of market participation by individuals who have received no proper training about trading in financial markets. These individuals often enter the market for speculative reasons having neither a specific information advantage nor a specific investment strategy motive.

Cheap brokerage accounts and widespread smart-phone technology could actually fuel an increase in 'illiterate' participation in the financial markets, i.e., participation by investors that are not able to fully assess risks and opportunities provided by different assets.

In other words, in a regime of easy access to financial trading platforms, financial illiteracy exposes individuals to over-indebtedness, excessive risk-taking, fraud, or cyber risks.

Nowadays, this concern is amplified by the role of social media & influencers as they can coordinate thousands of retail investors toward investments (aka, meme stocks) that may reflect temporary enthusiasm without any solid long-run fundamentals.

Taking India as an example, we have seen a huge surge in retail participation, directly or indirectly in the equity market. Though a large portion of investment comes through indirect channels like mutual funds, there is clearly an indication of interest in direct participation as well. Recent crossing of 100 million DEMAT accounts in the country is a testimony for the same. This growth has been primarily fueled by three things –

1) Increase in savings combined with low interest rates over last 24 months during covid.

2) Easy access to equity markets through discount broking platforms and digitised onboarding.

3) Active role played by social media and influencers thereby creating and environment of FOMO (fear of missing out)

While there is no doubt that the rise in retail investors in emerging economies helps the equity markets in becoming more resilient (as witnessed in India over the last 6 months), we should also be concerned about 'excessive' retail trading backed up by poor knowledge of financial markets. This phenomenon could actually increase irrational price patterns, financial instability and ultimately wealth inequality.  What could be a solution to excessive participation?

Fortunately, the answer is simple: Take financial education seriously and invest more in it! Basic financial education will help to increase financial participation. There have been numerous steps taken by regulatory bodies in India to continuously increase financial awareness & knowledge of risks associated with investing and trading in stocks (and other alternative assets) to protect their vested interests. Continued-and-updated financial education will help facilitate awareness among both current and future market participants.    

Prof. Mariano Massimiliano Croce, Full Professor of Finance, Bocconi University - SDA Bocconi Asia Center, Mumbai and SDA Bocconi Alumni Prabahan Sarkar, Deputy Manager – FS Technology Consulting, Protiviti India .

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First Published: 24 Sep 2022, 12:00 PM IST