- 14 Jan 2009
- Working Paper Summaries
Smart Money: The Effect of Education, Cognitive Ability, and Financial Literacy on Financial Market Participation
Overview — (Previously titled "If You Are So Smart, Why Aren't You Rich? The Effects of Education, Financial Literacy and Cognitive Ability on Financial Market Participation.") Individuals face an increasingly complex menu of financial product choices. The shift from defined benefit to defined contribution pension plans, and the growing importance of private retirement accounts, require individuals to choose the amount they save, as well as the mix of assets in which they invest. Yet, participation in financial markets is far from universal in the United States. Moreover, researchers have only a limited understanding of what factors cause participation. Cole and Shastry use a very large dataset new to the literature in order to study the important determinants of financial market participation. They find that higher levels of education and cognitive ability cause increased participation—however, financial literacy education does not. Key concepts include:
- The relationship between education and savings is difficult to measure, because both are affected by many factors (motivation, ability, etc.). This paper documents an important causal relationship between education and financial market participation.
- A set of financial literacy education programs, mandated by state governments, did not have an effect on individual savings decisions.
- It is imperative to conduct rigorous evaluations of financial literacy education programs to measure their efficacy.
Household financial market participation affects asset prices and household welfare. Yet, our understanding of this decision is limited. Using an instrumental variables strategy and dataset new to this literature, we provide the first precise, causal estimates of the effects of education on financial market participation. We find a large effect, even controlling for income. Examining mechanisms, we demonstrate that cognitive ability increases participation; however, and in contrast to previous research, financial literacy education does not affect decisions. We conclude by discussing how education may affect decision-making through: personality, borrowing behavior, discount rates, risk-aversion, and the influence of employers and neighbors.