FINANCIAL LITERACY CONFIDENCE AND STOCK MARKET PARTICIPATION AMONG GERMAN HOUSEHOLDS
FINANCIAL LITERACY CONFIDENCE AND STOCK MARKET PARTICIPATION AMONG GERMAN HOUSEHOLDS
Table of Contents
Abstract 3
1 Financial Literacy Confidence and Stock Market Participation Among German Households. 4
1.1 Data. 4
2 Methodology. 4
2.1 Hypothesis. 4
2.2 Model 4
2.3 Variables. 4
2.3.1 Dependent 4
2.3.2 Independent 4
3 Analysis & Results. 5
3.1 Descriptive Statistics. 5
3.1.1 T test 5
3.2 Regression Analysis. 6
3.3 Robustness & Endogeneity. 8
4 Discussion & Conclusions. 10
4.1 Financial literacy in Germany. 10
4.2 Stock Market Participation and Overconfidence. 11
4.3 Literacy Confidence and The Proportion of Financial Wealth Invested in The Stock Market 18
5 Conclusion. 19
6 References. 21
7 Appendix. 23
The current study aimed to investigate the impact of financial literacy confidence on stock market participation. Using the “save2009.dta” dataset, which is data from a 2009 survey, the study tested relevant hypotheses. The survey focused on retirement and savings provision in Germany. Most previous studies have associated financial literacy with an increase in the stock market participation. Nevertheless, stock market participation is still low, even as people become more and more financially literate across the world. Studies have also investigated the relationship between stock market investment and financial literacy, and concluded that financial literacy has a positive influence on investment decisions, especially on low-cost funds. The researcher also found out that a person’s financial knowledge will influence their investment decisions. The study used two hypotheses to investigate the issue of financial literacy in stock markets. The first hypothesis was that financial literacy overconfidence positively impacts the analysis supported stock market participation. This is in line with the literature, which supports the fact that knowledge of the stock market will allow a person to engage more in the stock market. The second hypothesis that states financial literacy overconfidence increases the proportion of financial wealth invested in the stock market was also supported by the analysis and previous literature as well.
1.1 Data
The data used in this study was “save2009.dta”, which is data from a 2009 survey. The survey focused on retirement and savings provision in Germany. The survey focuses on an array of variables, including the demographic variables of the participant, their investment behavior, and their financial literacy among others. The study population was a German household.
Data analysis is done using regression and descriptive statistics. The inferential statistics (regression in this case) was used to investigate the relationship between the outcome and independent variables. This involved testing the following hypotheses:
2.1 Hypothesis
H1= financial literacy overconfidence positively impacts stock market participation
H2= Financial literacy overconfidence increases the proportion of financial wealth invested in the stock market
2.2 Model
It is an approach that is applicable when the research incorporates the modelling and analysis of many variables, where the correlation constitutes a dependent variable and one or more independent variables (Harrell, 2015). The basic form regression models involve independent variables (X), the dependent variable (Y) and unknown parameters (β). The regression model usually identifies the link of a dependent variable (Y) to a function integration of unknown parameters (β) and independent variables (X).
Y ≈ f (X, β)
The equation can be useful in predicting the value of ‘Y’ in case the value of ‘X’ is known, and both ‘Y’ and ‘X’ are two sets of measures of a sample size of ‘n.’
In more detail, the regression model is represented as follows:
Y= β0 +β1X1 + β2X2+………. βnXn + ⱸ
2.3 Variables
2.3.1 Dependent
The dependent or come variables in this study were two: stock market participation, and the amount, or proportion of financial wealth a person invests in the stock market. The code for the stock market participation is main function of stock market, with fflit7s as the code.
2.3.2 Independent
The independent variables in this study were financial literacy overconfidence, and from the data set, this variable was represented by the following statements and codes: fflit_g1 for perceived personal knowledge of economic issues, fflit_g2 for perceived personal knowledge of financial issues, fflit_g3 for perceived personal knowledge of retirement planning, and fflit_g4 for perceived mathematical skill. Other independent variables examined in this study included gender, education, and age. Variables such as gender, however, were more of a control variable in this study.
3.1 Descriptive Statistics
Descriptive statistics refers to an analysis of data that helps describe and summarize data in a purposeful manner such that, for instance, patterns might appear from data (Bickel et al., 2012). However, the approach does not allow researchers to draw inferences beyond the analyzed data or reach conclusions basing on any hypothesis made. They are usually a way to describe data. Descriptive statics is quite significant since it will be difficult to envisage what is incorporated in the data in case, we present raw data, mainly when it is a lot. Therefore, it allows data to be presented in a more purposeful manner, which enables straightforward interpretation of data. Moreover, descriptive statistics are also useful in the spread and distribution of data. Typically, there are two classes of statistics used to describe data and they incorporate Measures of central tendency, which refers to methods used to describe the central position of the frequency distribution for grouped data. Measures of spread are ways that summarize a group of data by defining how data is spread. In order to describe spread, several statistics are available to the researcher, incorporating quartiles, ranges, variance, standard deviation and absolute deviation. Descriptive statistics are essential such that they provide quantitative statistics in a manageable form. They appropriately simplify large quantities of data by reducing lots of data into a simple summary.
The descriptive statistics performed in this case consisted of the minimums, the maximums, the means, and the standard deviations as shown in the output below:
3.1.1 T test
In the output below, the analysis investigated whether or not financial overconfidence differs between men and women. H0 is the null hypothesis that is being tested, and the t test seeks to evaluate the null hypothesis that the mean over confidence between men and women is the same. The values Pr (T < t), Pr (T > t) are the one tailed p values used to evaluate the null hypothesis against other alternative hypotheses. The left test indicates that the mean is less than a given value while the right test indicates that the mean is greater than a given value. All the probabilities in this case are calculated using the t distribution as shown in the output below. Since the p value is less 0,05, which is the alpha level, the conclusion is that the mean overconfidence is statistically significantly different between men and women. This is also confirmed by the Pr (|T| > |t|) value, which is also less than the alpha level.
3.2 Regression Analysis
Regression analysis provides comprehensive information that can be further applied to improve products and services. In order to understand the levels of market participation, researchers present to follow up surveys to understand how financial literacy confidence prompts market involvement. Regression analysis allows researchers to measure the levels of confidence that investors associate with while engaging in stock markets, and related factors influencing investment in stock markets. Regression analysis is useful in a statistical approach that can be leveraged to determine the extent to which certain independent variables influence dependent variables.
The proxy for financial literacy’s role in investment in the stock market is financial literacy: the primary function of the stock market. The variable code is fflit7s.
To represent overconfidence and under confidence, the following variables were used, and they are tabled as follows:
fflit_g1
perceived personal knowledge of economic issues
fflit_g2
perceived personal knowledge of financial issues
fflit_g3
perceived personal knowledge of retirement planning
fflit_g4
perceived mathematical skills
In this case, the analysis investigated the relationship between financial literacy overconfidence/under confidence and investment in the stock market. The hypothesis being tested is as follows:
H1= financial literacy overconfidence positively impacts stock market participation
The Prob > F = 0.0000, and this is less than 0.05, which indicates statistical significance, and as such, the alternative hypothesis H1 is supported. The conclusion made is that financial literacy overconfidence significantly impacts stock market participation.
H2= Financial literacy overconfidence increases the proportion of financial wealth invested in the stock market
To test this hypothesis, the researcher identified the variable (s) that represent the amount or proportion of wealth a person invests in the stock market and the variables that represent financial literacy overconfidence or under confidence. The variables that represent overconfidence or under-confidence are still the variables shown below.
fflit_g1
perceived personal knowledge of economic issues
fflit_g2
perceived personal knowledge of financial issues
fflit_g3
perceived personal knowledge of retirement planning
fflit_g4
perceived mathematical skills
The proxy for the financial wealth invested in the stock market is possession – shares and real-estate funds. This variable shows the amount that a respondent has invested in the stock market in the form of shares. The analysis sought to investigate if this had any relationship with the confidence of an investor in his or her financial literacy skills. The code for this variable is f72m_6
The Prob > F = 0.0000, and this is less than 0.05, which indicates statistical significance, and as such, the alternative hypothesis H2 is supported. The conclusion made is that financial literacy overconfidence increases the proportion of financial wealth invested in the stock market.
3.3 Robustness & Endogeneity
Robustness test helps detect misspecifications, where the researcher evaluates how targeted regression coefficients behave whenever variables are added to the regression (Chen et al., 2015). The robustness of the regression coefficient is considered as evidence of structural validity. To ensure the robustness test is informative, researchers select variables to be added to regression carefully. When explanatory variables in regression are associated with disturbance, the robustness test is applied to draw appropriate conclusions.
On the other hand, endogeneity occurs when a variable, whether observed or not observed, which is not incorporated in our models, is related to the variable included in our models. It might be argued that financial literacy could be a result of choice (endogeneity) and not exogenous with respect to risk tolerance, i.e., investors who engage in risky projects presumably have high levels of financial literacy confidence. A robustness check is used to track how conclusions change when assumptions are changed. It is also demonstrating that the main analyses are okay.
The question, in this case, therefore, is whether or not we have an endogeneity problem. In other words, if there is another variable or variable that affects the outcome variable, which in this case is stock market participation, then we have an endogeneity problem. This means that the analysis can produce accurate results using conventional methods. In the analysis, the focus is on financial literacy confidence and how it can affect stock market participation, and the amount of wealth a person invests in the stock market. Previous research, however, suggests that age, gender, and a person’s level of education are just a few examples of other variables that could significantly affect a person’s stock market participation and the amount of wealth as they invest in the stock market. The variables mentioned above could have an impact on both financial literacy overconfidence and stock market participation.
In this case, we test the hypothesis that the age of a person; their education level affects both their participation in the stock market and the wealth they invest in the stock market as follows:
From the output above, it is clear that gender (f06s) and age (f07o) all have a significant impact on stock market participation (p value =0.000, which is less than 0.005). The critical value is 0.05 because the analysis is carried out at 95% confidence level.
Testing the effect of the same variables on the amount of wealth that a person invests in the stock market; we have the following output:
From the output, it is clear that age does not have a significant impact on the proportion of wealth a person invests in the stock market. Gender, on the other hand, significantly impacts the proportion of wealth a person invests in the stock market.
In this analysis, a further investigation is carried out, where the value of age is squared, and in Stata, it has been coded as f07o2. The output is as follows:
From the above output, it can be seen that the square of age is also not significant. What this means is that when people get older, the proportion of wealth they invest does not significantly change. However, an important observation is that the variable ‘age’ (f07o) has a positive coefficient, while the variable ‘age squared’ (f07o2) has a negative coefficient, and what this means is that as people grow older, the impact or effect of age is lessened.
What this means, therefore, that in the analysis of the impact of financial literacy overconfidence or under-confidence in the stock market participation and the proportion of wealth an individual invests in the stock market, variables such as age, gender, and education level should be taken into account.
4.1 Financial literacy in Germany
A study by Bucher-Koenen & Lusardi (2011) investigated retirement planning and financial literacy in Germany and established that financial literacy varied by gender and education. More women generally lack the basic financial concepts, and the same was observed for the less educated and those living in East German. When the study by Bucher-Koenen & Lusardi (2011) compared East and West Germany in terms of financial literacy, they established that there are people that have low education and low income on both sides, but in the same categories, people in East Germany have little financial literacy compared to the western part.
The researchers also investigated whether or not there exists a causal relationship between retirement planning and financial literacy, and they find out that there exists a positive effect of financial knowledge on retirement planning among the Germans. These findings have been reiterated by many other studies such as Müller & Weber (2010) and Van Rooij, Lusardi & Alessie (2011) among others, which focused on different countries and research contexts.
Lusardi & Mitchell (2014) investigated financial inclusion and financial literacy in Germany, and some of the fundamental questions that this researcher asks to include the importance of financial literacy to society, individuals, and central banks, what drives financial literacy, and mainly, what role does financial education play, and finally, the implications for policymakers. Van Rooij, Lusardi & Alessie (2011) noted that the financial capabilities including the economic behavior of the households, among the Germans are, on average, competent. This incorporates activities such as planning unexpected expenditures, managing day-to-day spending, and looking ahead among others. Financial literacy, as defined by the OECD, is a combination of knowledge, awareness, attitude, skill, and behavior that is necessary for making sound financial decisions, and most importantly, in achieving individual or collective financial wellbeing.
Different national surveys have thus far been carried out to measure financial literacy, but there have not been measures available to do this. Studies such as Lusardi & Mitchell (2011), however, came up with different measures, for example, the three simple questions shown in the image below:
When investigating financial literacy among German households, Buch (2017) focused on three main variables, and which are financial knowledge, financial behavior, and financial attitudes. As far as financial knowledge is concerned, the research established that about 56% of Germans achieved a score of 5 and above out of 7. This is what the researcher considered as the minimum target score for financial knowledge. As far as financial behavior is concerned, it was established that about 51% of the respondents met a minimum target score of 6 out of 9.
The study established that the weakest area of this variable included choosing products, budgeting, planning and using independent advice. As far as financial attitudes are concerned, Buch (2017) established that the respondents tended to show short-termism, since they tended to focus more on living today, and thus, spending more money today as opposed to planning more and setting financial goals. About 50% of the respondents were reported to achieve the minimum target score for the variable ‘financial attitude’.
4.2 Stock Market Participation and Overconfidence
Stock market participation is a phenomenon that has attracted the attention of researchers such as Lusardi & Mitchell (2014) and Lusardi & Mitchell (2014), among others, who generally found out that financial decision making by an individual is affected by their level of financial literacy. Studies have also established that people labeled as ‘low literate tend to be less likely to invest in stocks, which means that they are less likely to participate in the stock market (Calcagno & Monticone, 2015).
People have become more and more financial responsibility, and the reason behind this, according to Müller & Weber (2010), is the fact that there have been structural reforms and market liberalization, especially in social security plans and pensions. As much as most previous studies have associated financial literacy with an increase in the stock market participation, the stock market participations are still low in general, even as people become more and more financially literate across the world.
Akims & Jagongo (2017) also pointed out that there are differences in stock market participation among different countries, and this is what the researchers have referred to as the stock market participation puzzle. Financial literacy is not the only factor that academic literature has focused on in the recent past, as Lusardi & Mitchell (2014) explain. This is because other important individual characteristics such as gender, age, risk aversion, gender and education also influence stock market participation. The stock market participation rates in countries within Europe differ, even if there is no significant difference in the average household wealth in these countries. However, Calcagno & Monticone (2015) found out that countries that have above average household wealth tend to have higher rates of stock market participation. Studies such as Hong et al. (2004) found out that social interaction is one of the most critical factors that can be used to predict stock market participation, and this means that in cases where there is a sociable community, stock market participation would be less impacted by financial literacy. This means that country-specific factors or variables moderate the existing relation between factors such as financial literacy and stock market participation, and in the current study, the focus was on Germany.
Müller and Weber (2010) investigated the relationship between stock market investment and financial literacy and concluded that financial literacy has a positive influence on investment decisions, especially on low-cost funds. Müller and Weber further argue that even in the cases involving sophisticated investors, they (investors) would prefer actively managed funds as opposed to exchange-traded less expensive funds. Different studies have investigated different countries and market contexts and established that the factors influencing investments differ significantly. Mahmood (2011), for example, carried out a study in Pakistan, and the aim was to investigate the influence of socioeconomic and demographic factors on investment decisions on the stock market. He established that risk perception plays a crucial role in making the investment decision, but other factors include changes in government policy, which were established to play an essential role in the risk perception of an investor.
Different studies such as Akims & Jagongo (2017) and Grinblatt & Keloharju (2009), among others, have thus far found out that a person’s financial knowledge will influence their investment decisions, and this has been consistent throughout the world. Often, the higher the financial knowledge of this individual, the better the investment decision they are likely to make. Some studies such as Calcagno & Monticone (2015) have also argued that factors such as gender could affect an investment decision and others, such as the age of the investor as well.
As far as age is concerned, Müller & Weber (2010) explained that older investors would think more about retirement than the younger investors, and what this means is that older investors will make more active investments in aspects such as retirement schemes, especially pension schemes. Investors are less likely to be misled on financial matters if they have high financial literacy levels and knowledge. Individuals with lower levels of financial literacy, on the other hand, are more likely to be misled in making investment decisions, since they rely on others for financial advice, and in such cases, individuals make investments based on the previous investments made by others (Akims & Jagongo, 2017).
By definition, financial literacy generally refers to a person’s knowledge about different financial concepts, which also affects their ability to make both short term and long-term investment decisions while taking into account important factors such as the changing economic conditions (Grinblatt & Keloharju, 2009). Participation in the stock market requires a high-level understanding of the financial market and how different variables are related to one another. The patterns and trends in stock returns and performance on any stock market often cannot be predicted with accuracy, but with adequate knowledge, an investor is in position to carry out both technical and fundamental analyses to help them in understanding what happens in the stock market, which by extension, will influence their participation.
Thus far, it is clear that the problem of low stock market participation is almost ubiquitous, and as Müller & Weber (2010) explain, well-functioning capital markets are strongly dependent on the participation levels in a particular country. These studies have also agreed that one of the ways of ensuring that stock market participation has been enhanced is ensuring that financial literacy has been promoted at all levels, and across the world, because low stock market participation is not only a problem in the developing world but in the developed world as well.
The analysis in this study has revealed that financial literacy could have some impact on stock market participation, but financial literacy itself is impacted or affected by an array of factors. Stock market participation as well is determined by many other factors apart from financial literacy. Studies have cited factors such as gender, age, and even levels of income as critical determinants of stock market participation. Van Rooij, Lusardi & Alessie (2011) pointed out that factors such as personal financial management practices play a vital role in the making of investment decisions. Financial management practices could include, among others, expenditure practices, savings practices, investment money management, and debt management.
In many contexts, stock market participation has been considered as a sign that the consumer is doing well financially, and this has also been the basis of investigation between the relationship between financial literacy overconfidence and stock market participation. Chu et al. (2017) pointed out that financial literacy overconfidence is a crucial factor that can be measured by obtaining the difference of the objective and the subjective/idiosyncratic financial literacy measures/ scores. To generate asset-based income, many households in Germany and elsewhere use stocks. Theoretically, one would say that the stock market acts as a means for households to facilitate the allocation of their assets over many periods more effectively. Calcagno & Monticone (2015) point out that in theory, once an individual or a household can effectively invest in the stock market, then their financial wellbeing would be enhanced, particularly in the long term.
In reality, however, the study has shown thus far, that many families or individuals do not participate/actively take part in the stock market. This is evidenced by the low rate of stock market participations, as many researchers have already pointed out. The current study, however, investigates how the main variable ‘financial literacy overconfidence’ is likely to affect a person’s participation in the stock market, or the decisions to invest in stocks among the German households. It is reasonable to assume that individuals who are financially literate or households that are generally literate financially, are likely to have optimistic biases, and this can affect their economic behavior, and by extension, their participation in the stock market. Xia, Wang & Li (2014), for example, established that households or individuals that are overconfident would, in most cases, engage in risky/high level investment behaviors, and as such, these individuals or households are more likely to participate in the stock market. This is consistent with the findings of the current study since it was established that financial literacy overconfidence tends to increase the likelihood of an individual or household to invest in the stock market.
The term overconfidence, as used in this empirical study, could be defined as the overestimation of a group’s or an individual’s ability, level of control, performance, or level of success (Lusardi & Mitchell (2014). This is why, in the context of the stock market, an overconfident individual tends to be more optimistic of a positive outcome as a result of their investment actions, or any other economic activities. Most of the previous literature in finance has linked overconfidence with risky investment or money management behavior (Xia, Wang & Li, 2014), although in some cases, risky investment decisions could result in high returns. Some investors tend to overestimate the value they are likely to create by making a particular investment decision because of being overconfident.
More specifically in the stock market, Xia, Wang & Li (2014) believe that overconfidence has been linked with turnover and trading volume; for example, researchers such as Grinblatt and Keloharju (2009), in their empirical analysis, established that a unit increase in the overconfidence of an investor leads to about 4% increase in the stock market trades. Grinblatt and Keloharju also investigated how overconfident traders performed on the stock market and established that this type of trades tends to exhibit negative portfolio returns or performance, and what this does is that it rules out the effects that may arise from superior information.
In the investigation of overconfidence in the financial context, many studies such as Xia, Wang & Li (2014) argued that gender plays an important role, where males are more likely to be overconfident as compared to females. These studies had used gender as a proxy for overconfidence, and in their analyses, established that males are more likely to trade as compared to females. What the current sought to do was to link financial literacy overconfidence and the participation of an investor in the stock market, which, as the research finds out, and consistent with the existing literature, financial literacy overconfidence is positively associated with stock market participation. The reverse is also true, such that financial literacy under confidence is associated with lower rates of stock market participation.
The study also investigates the effects of financial literacy overconfidence on the proportion of financial wealth that is invested in the stock market. Generally, financial literacy overconfidence tends to increase the amount of financial wealth that is invested in the stock market, since as Müller & Weber (2010) explain, overconfident investors tend to believe that they will have positive returns. Chu et al. (2017), in the investigation of households’ financial literacy, the portfolio choice, and their financial wellbeing, established that households that were classified as having higher financial literacy, particularly those that were classified as having higher levels of advanced financial literacy, exhibited a likelihood of delegating part of their portfolio to the experts. They also preferred investing in mutual funds. The overconfident households, on the other hand, seemed to choose to invest by themselves, and their portfolios constituted mainly of stocks. The households that were characterized by higher financial literacy, therefore, were more likely to receive positive returns on their investments compared to those with overconfidence in their financial literacy.
Financial literacy, despite having been one of the essential aspects that researchers focus on for a while now, has not yet adequately been linked with how different households in Germany or elsewhere, choose among different assets (Chu et al., 2017). Studies such as Bailey & Ng (2006) focus on the financial choices and diversifications by household, but even with the availability of trading data, researchers have generally failed to measure financial literacy accurately. Linking financial literacy of a household and its financial outcomes requires that the researcher can measure all the relevant variables involved as accurately as possible.
Studies such as Chu et al. (2017) tested hypotheses on the relationship between high financial literacy and the chances of investing in stocks, and the relationship between high financial literacy and the likelihood of the households to delegate part of the portfolios to invest in mutual funds and to fund managers. The conclusion in that particular study was that financially literate and overconfident households are likely to invest in stocks only, while those financially literate, with high-level financial knowledge, are likely to delegate their investment decisions to experts and invest more in mutual funds as well.
Empirical research ascertains that market participation is a result of several factors incorporating risk aversion, education and age, entry costs, social interaction, and social capital. Financial literacy, which is considered as an investment type in human capital, tends to have significant impacts on the management ability of savings for retirement. It is also evident that financial literacy has influenced participation in the stock market significantly. Luca (2015) claimed that a lack of financial and economic knowledge is an important disincentive of participation in capital markets, and those with little knowledge in finance are not likely to invest in stocks. Moreover, it will less possible for those who are financially illiterate to accumulate wealth and plan for retirement. Lack of awareness of fundamental financial principles tends to have serious and actual effects. A study, to compare the investment patterns and wealth of individuals with or without financial education, established that individuals with financial knowledge were likely to invest and accumulate more wealth than their counterparts. Such findings imply that providing financial education to people about investment in the stock market and retirement planning will change and improve on the way individuals execute their plans. This is consistent with Alessie et al. (2011) study, which indicates that stock market participation increased with an increase in financial literacy levels. It further highlighted that, improvements on advanced and basic financial literacy levels translated to an increase in the market participation frequency. Advanced financial literacy involves detailed calculations on returns/risks and viability of investments done on stocks and bonds, whereas basic financial literacy entails simple calculations on stocks gains, return on a bond, time value of money and inflation. It is clear enough that levels of confidence in financial literacy affect the market participation of investors more compared to other aspects such as income and financial education of stock ownership (Mendes, 2010).
Research suggests that literacy in finance is crucial to a market economy since literate consumers are capable of demanding products to meet their long-term and short-term financial needs, with traders striving to provide products well characterized to fulfill those demands (Nelson et al., 2013). High levels of financial literacy confidence tend to increase the responsibility of individuals on their financial security and prompt investment behavior. Research indicates that primary financial education is not only important to families and individuals but also the communities since literate consumers can make better decisions, thus resulting in the marketplace which is effective and efficient.
There is a high probability of individuals with financial knowledge to utilize financial planning tools. However, those who are unable to plan for retirement are deemed less aware of fundamental economic aspects affecting their economic status (Hastings et al., 2013). Individuals with low levels of financial literacy and overconfidence in financial matters are more likely to make poor financial decisions, which in turn results in losses.
One of the significant aspects resulting in this issue is an individual’s macro-level experience. For instance, a study conducted in Italy indicates that individuals exposed to the inflation problem had more self-esteem than challenges associated with inflation. Mutual funds hold indirect investments in the stock market and, the classification of investment funds is based on their passive and active management strategies. Investors with high financial literacy levels prefer passive investment funds due to their lower commission funds. Additionally, investors with low financial literacy level channel their funds to traditional investment which leads to extra payment of commissions and taxes. Some disparities exist in an individual’s wealth levels based on their financial literacy status, whether high or low. Due to this, individuals with high literacy levels and confidence direct their funds to the stock market with higher premiums (Alessie et al., 2011).
Moreover, financial literacy was identified as lower among certain groups of people in the society, such as individuals with low education levels, women and minority groups in the society. Basic financial knowledge is useful in resolving the situation that results in bad debt behavior, lack of stock market participation and failure of households to plan for retirement (Rasheed et al., 2016). In Turkey, the proportion of foreign investors investing in stock markets is high compared to domestic investors. Lack of direct investment of the households’ savings to capital markets affects many stakeholders significantly at the macro and micro level and deter the operation of financial markets, particularly incorporating stock markets. The implication of investors’ behavioral patterns, identification and enhancement of financial literacy will increase participation patterns of stock markets (Lusardi, 2014). Some scholars concluded that the level of financial literacy and its severity as a non-economic aspect of stock market preferences directs individuals to participate in stock markets. High financial literacy leads to more considerable accumulation of wealth with education strengthening this impact particularly for women, but not so for men. Research further indicates that men’s wealth increases in confidence, while there is barely any confidence effect for women. Lack of confidence affects financial decisions and literacy, thus leading to stunted growth of knowledge and uncertainties in decision making. Investors with high levels of confidence are likely to make informed decisions and in turn, invest in stock markets as opposed to those with low levels of confidence. It was argued that cognitive ability and literacy affect preferences such as risk aversion and impact on decision making. This suggests that people with low levels of financial knowledge are less likely to undertake risks and, consequently, one must possess specific financial knowledge to understand and evaluate risks linked to investment products (Mendes, 2010). Thus, financial risk tolerance is a decisive aspect influencing the saving and investment behavior of individuals. It incorporates several aspects of risk such as retirement planning, borrowing, saving and insurance.
Consumer’s knowledge about finance is an essential step towards participation in the stock market as has been reiterated throughout this study. Just as in many countries, in German, the organization of social security has changed significantly. Confidence in literacy informs investment decisions. People these days are becoming conscious and responsible for the security of their finances (Bucher-Koenen and Lusardi, 2011). The introduction of more complex products (financial products) seemed to increase over time. There is very little/minimal information on whether individuals or households have the information/knowledge to walk through the financial environment and how that affects investment decisions.
Many individuals from European households look forward to financial institutions to give them advice. Confidence is derived from the advice given, and, in some instances, it might lead to overconfidence. Financial advice is key for households to decide whether to participate in the stock market and other financial decisions. Most of the new financial products are complex emphasizing the need for financial advice (Williams, 2007). Many households may depend on advisors or other financial players and their dependence on this advice considerably varies from one household to another. This is brought about by the financial ability of the family and the extent they trust it. Households financially stable or that lack confidence in the financial advice provided considerably affects the participation in the stock markets.
Individuals who in their wisdom, believe they have adequate information about finances, they are likely to be overconfident. What this, therefore, means there will be more investment and more financial decisions. Many people are likely to suffer losses as some may make unsound decisions based on what they thought was adequate information. Overconfidence, therefore, can lead to more activities in the stock market that likely to be sustainable.
Taking part in the stock market is always seen as a sign of consumer financial stability. The financial literacy overconfidence has a positive relationship with participating in the stock market. Studies have shown that the demand for financial advice could be as a result of financial literacy (Calcagno and Monticone, 2015). Financial literacy is a widely embraced phenomenon and dramatically affects the way financial decisions are made Lusardi and Mitchell, (2014). More informed investors look for financial advice which means expert advice is not a replacement of financial literacy and a compliment. Consumption of such advice and information informs sound financial decisions to investors in order to maximize returns. The availability of financial advice inspires more investment decisions and at times, may lead to overconfidence which may also translate to more activities on the stock market.
The relationship between Seeking financial advice and various financial literacy measures remains an issue that should subject to more studies. Heath and Tversky (1991) observed that people are more willing to depend on their judgment when they see themselves as more knowledgeable. Financial literacy affects the behavior of those who take part in the stock market and those who do not take part. An individual who was willing to invest, after getting financial, might decide not to since he is exposed to more analysis of the implication of his investment decision and he may decide to dwell on one negative aspect.
Financial crisis often erodes confidence in financial institutions because many financial products are assumed to benefits banks and other financial institutions than individuals. Policymakers have therefore become concerned about the lack of confidence that may have on households to take part in financial markets (Georgarakos and Inderst, 2014). The perceptions of households and their trust in financial institutions affect their need to involve in risky financial assets. Financially stable households can decide to depend on the advice of the financial advisors. The specific preferences and needs in line with the availability of cash or the status of tax of a household largely depend on financial capability and the available advice in order to choose from the full range of financial products Huberman and Jiang, (2016).
Overconfidence is generally the overestimation of an individual’s ability, level of control, performance or success. Overconfident investors tend to be optimistic about positive results arising from their actions, and usually consider themselves more skillful and less risky. Overconfident are likely to engage in competitive games and markets. Low et al. (2012) found that there is a positive correlation between risky investment and CEO overconfidence. However, overconfident CEOs might overestimate the value-generating possible opportunities in a merger. This will lead to higher reservation of the target and hence negatively affecting the wealth of shareholders. Results have shown that for every unit increase in the variable ‘overconfidence’, there would be a 4% rise in stock market trades. Some contradicting literature, however, indicates that overconfidence investors exhibit negative performance which overshadows the impacts arising from superior information. Optimistic biases affect economic behavior, specifically stock market participation and investment. Individuals/people/households that are considered under-confident as far as financial literacy is concerned are unlikely to participate in stock markets. Overconfident investors usually privilege their information compared to information that is publicly available to all investors. They follow their ideas more than the advice of others and use unjustified stock market rules so long as they are satisfied, and usually responsible for their portfolio of management securities. Some risk-neutral investors overestimate the precision of their private information and invest in markets of well-informed traders with rational anticipations. Their involvement in market results to higher transaction volumes, more volatile and considerable depths and informative prices. Overconfidence had a far-reaching impact on global knowledge of assets but had a significant influence when it comes to risk aversion and investment (Michailova et al., 2017). In the context of stock markets, financial literacy overconfidence makes investors believe that they are well aware of the market and capable enough to handle any fluctuations.
Findings suggest that rationality might be dominated by overconfidence and thus not survive for the long term. Therefore, overconfident investors will record more profits that rational investors due to their willingness to undertake risks. Investors a subject of overconfidence are always committed and normally do better than unconfident traders when exploiting mispricing caused by liquidity or noise investors. Overconfident investors perceive investment to be safe, therefore, evaluates them with minimal considerations (Tobler et al., 2017). Due to this, investors will consider several investment projects to have a positive net value making them invest excessively. Evidence shows that highly convex contracts usually incentivize overconfident investors. In some cases, these investors also invest in projects with negative net present value due to their optimistic nature in investment opportunities, hence overinvestment. Overconfidence leads investors towards understanding risks associated with the investment, trading excessively, and overstating their stock market knowledge which significantly affects the investment behavior and performance in stock markets. On the other hand, it was found that high levels of overconfidence among traders result in welfare reduction. This is because overconfident traders are more active and, as a consequence, incur losses such as being outperformed by small traders. Luong (2011) concluded that under-confident traders are less likely to engage in irrational behaviors instead of process only relevant information.
In German, the pattern concerning consumer freedom has been promoted further by two issues; the 2001 reformed pension scheme started by the federal republic of Germany to help retirees on investment and saving decisions. The government reduced benefits granted by the state to encourage individuals to participate in private pension schemes and subsidized pension schemes by the state. The second is, most German households are more interested in accumulating wealth as opposed to getting returns on investments Alber, (2003).
4.3 Literacy Confidence and The Proportion of Financial Wealth Invested in The Stock Market
The conflict between investors and advisors may compromise the value of advice. For instance, advisors may get a higher commission than others on some products. Individuals who invest in risky assets or group investments face a higher risk of being defrauded Guiso et al. (2008). The risk goes down with more legal protection. Individual households will also perceive the profession financial advice differently and their trust will also vary. It is generally observed that households with higher financial capability are much more interested in how legal protection is there concerning financial services in order for them to participate in the stock market.
Every household has its perception and these differences are quite important economically as analyzed by Bulter et al. (2009), and these perceptions lead to different levels of trust. They further argue that the differences in perceptions may be deeply rooted because they are acquired in the family and they are subject to much apathy. Studies show that households make less optimal financial decisions because of the limited extent of financial literacy. People who are financially less literate do not have the habit of saving; they tend to have more debts, save less for retirement and accumulate less wealth.
Most households in Germany prefer to use a conservative approach to investment. Accumulation of property appears to be the best option since many are sceptical of the participating in the stock market and other investment options because they are unsure of the returns. This is the reason they have preferred a more conservative approach. As earlier indicated, since advisors appear to get the big junk of the profits, many individuals see it as something unwise to invest in a program, someone else is likely to benefit more than the investor himself.
Different households have to depend on financial advice at various levels in line with their financial ability. For the households that have to depend on the financial advice, then trust in the advice it becomes an essential aspect for them to be willing to invest in risky assets. This is only possible when the financial capability is substituted by education or the expected financial complexity. Households more educated or those that see making financial decisions is complicated, what is important to them is if their rights as consumers are adequately protected for them to be willing to take part in risky assets (Lusardi and Mitchell, 2007b; Vaan Rooij et al., 2011b). The differences in views have a significant bearing on an individual’s willingness to keep risky assets, whether they rely on financial advice or their judgment. There will include a varied range of investments among individuals depending on their perception and literacy confidence levels.
This study explicitly focused on financial literacy confidence and how it affects financial investment decisions. By definition, financial literacy generally refers to a person’s knowledge about different financial concepts, which also affects their ability to make both short term and long-term investment decisions while taking into account important factors such as the changing economic conditions. Theoretically, it is speculated that the more knowledge and understanding one has, the more likely they are to make informed decisions on the financial market. In literature, this phenomenon has been investigated in detail, with researchers finding for the significant part a consensus.
Most previous studies have associated financial literacy with an increase in the stock market participation. It should be noted, however, that stock market participation is still low in general, even as people become more and more financially literate across the world. Researchers such as Müller and Weber (2010) also investigated the relationship between stock market investment and financial literacy and concluded that financial literacy has a positive influence on investment decisions, especially on low-cost funds. The researcher also found out that a person’s financial knowledge will influence their investment decisions.
The study used two hypotheses to investigate the issue of financial literacy in stock markets. The first hypothesis was that financial literacy overconfidence positively impacts the analysis supported stock market participation. This is line with literature as mentioned, which supports the fact that knowledge of the stock market will allow a person to engage more in the stock market. The second hypothesis that states financial literacy overconfidence increases the proportion of financial wealth invested in the stock market was also supported by the analysis and previous literature as well.
Participation in the stock market does not necessarily require a high-level understanding of the financial market based on how different variables are related to one another. The patterns and trends in stock returns and performance on any stock market often cannot be predicted with accuracy. However, with adequate knowledge, an investor can be able to conduct analyses such as technical and fundamental to help them understand what happens in the stock market, which by extension, will influence their participation. This shows that with more knowledge comes the ability to execute certain crucial aspects to position one at a better chance of getting higher returns in the stock market compared to one who does not know.
The term overconfidence, as used in this empirical study, could be defined as the overestimation of a group’s or an individual’s ability, level of control, performance, or level of success (Lusardi & Mitchell, 2014). In some cases, individuals are more optimistic of a positive outcome as a result of their investment actions, or any other economic activities they engage in. Most of the previous literature in finance has linked overconfidence to risky investment behavior even though in some cases, the high risk paid off through high returns.
Endogenous factors such as age have been seen to play a role from the literature on how they could influence the participation in the stock market along with financial literacy overconfidence. Factors such as gender, age, and even levels of income are vital determinants of stock market participation. Personal financial management practices play a crucial role in the making of investment decisions as well. Financial management practices could include, among others, expenditure practices, savings practices, investment money management, and debt management.
As far as age is concerned, Müller & Weber (2010) explained that older investors would think more about retirement than the younger investors, and what this means is that older investors will make more active investments in aspects such as retirement schemes, especially pension schemes. Age could also signify more knowledge and experience in investment, and thus they are likely to make more investments in terms of the wealth proportion compared to younger people. However, this study only explored the role of financial literacy overconfidence in the amount of wealth investment, as the issue of factors related to age can be one to explore in the future.
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Financial Literacy Overconfidence Variables
fflit_g1
perceived personal knowledge of economic issues
fflit_g2
perceived personal knowledge of financial issues
fflit_g3
perceived personal knowledge of retirement planning
fflit_g4
perceived mathematical skills
Gender -f06s
Age -f07o
F72m_6 – financial wealth invested in the stock market
Correlation matrix
Descriptive statistics
