Table of Contents
Financial stability has always been a major goal of every individual and household. Stock markets are one of the many ways households could generate incomes from financial assets. It is also clear that over the years, accessibility to the financial markets by small investors has increased with increasing number of financial services and products. Theoretically, stock markets are used as a means by which individuals allocate assets to multiple periods to serve their financial needs. Stock markets are seen as an effective investment channel for risk averse individuals and household because they enhance their long term financial wellbeing. However, participation in the stock market by households is very limited in reality. Households across the world have exhibited little participation in stock markets, including those in developed economies. Limited participation by households has been blamed on financial literacy. Individuals who feel that they have sound financial literacy are more likely to participate in the stock markets and vice versa.
Market Portfolio Theories, Ideas and Assumptions
There has been renewed interest in the causal relationship between financial literacy and stock market participation. Failure to participate in the stock market leads to considerably huge welfare losses to households for not participating in the stock market (Thomas & Spataro, 2015). The welfare loss come in form of less accumulation of assets and reduction in returns. From a financial analysis point of view, increased participation is expected to broaden and deepen financial markets leading to favorable market returns.
Studies have also revealed a positive correlation between cognitive abilities and participation in the stock market. Cognitive abilities affect individual behavior pattern in different scenarios. Higher cognitive abilities are associated with lower cost of information and low risk aversion. High cognitive abilities therefore lead to higher rates of participation in the market. In this regard, individuals with higher cognitive abilities are expected to show participation or strong willingness to participate in stock markets (Christelis, Jappelli, & Padula, 2010). Further studies also reveal that the intelligence quotient is participation in stock markets and IQ are monotonously related even when demographic and economic characteristics are controlled for in experimental studies (Hansen & Villa, 2015).
Financial literacy as an aspect of cognition also affects participation in the stock market in a similar way as the cognitive abilities. Cognitive abilities discussed above relate to how individuals react to and solve problems relating to financial investment. This relates to their emotional reactions and attitudes such as risk preferences. However financial literacy relates to the crystalized knowledge relating to financial markets. Financial literacy is “the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial well-being” (Hung, Parker, & Yoong, 2009). This is different from financial education which is a process through which the individuals improve their financial literacy.
Financial literacy relates to how individuals are able to make mathematical and other related evaluations of investments. Individuals with higher literacy levels are able to make direct relations between risk and return. Such individuals have higher ability to make investments in the stock market. Further understanding of how financial markets works also increases the likelihood of participating in financial markets. Some determinants of financial literacy include the level of education. Individuals with college education or more have more financial knowledge and are more likely to participate in stock markets than their counterparts with less or no education. The same applies to people with access to financial socialization agents such as educated parents, social media, peers groups and friends (Isomidinova, Singh, & Singh, 2017).
Statement of the Problem
While financial markets have grown rapidly making them more accessible to individuals and small investors, participation by households is still low. This is regardless of the financial challenges that people undergo after retirement. After retirement, individuals are expected to have greater control over their finances. However, their sources of income are limited to pension schemes which account for only a small percentage of their income needs. It is therefore important to understand the relationship between financial literacy and participation in financial markets. With growing accessibility it would be assumed that households would participate more in the stock markets to deepen broaden their asset portfolios and generate more income. This makes it necessary to understand the underlying cause of participation notably financial literacy. It also requires that we evaluate the financial literacy rates for further policy recommendations.
Households are finding themselves challenged by the myriad financial needs and the dwindling income generating opportunities. Most individuals work for corporations that make profits in order to pay their wages. On the back of the workers, other individuals make income off the performance of organizations. The more profitable an organization is, the more profitable it is to hold such a company’s stock. Lack of this knowledge and other financial literacy issue makes people less likely to invest in stock. Studies can benefit households by bringing their attention to new opportunities to broaden their financial assets and grow wealth.
Households make investment decisions from time to time. However, most households lack the basic knowledge of finance and cannot complete simple financial calculations correctly. As a result, the investment and saving decisions of most households are based on crude decision making methods or no such considerations at all. Households also fail to plan for retirement, save or invest for future financial needs because they lack basic financial literacy. This explains why people hold more and more debt and little wealth despite having modest incomes (van Rooij, Lusardi, & Alessie, 2011).
Linking Financial Literacy to Household Participation in the Stock Market
Studies reveal that 77 percent of the global population is financially illiterate. Men show greater literacy levels with a very small margin given that 65 percent of men are illiterate while 70 percent of the women are illiterate (Klapper, Lusardi, & Mitchell, 2015). This is a huge number considering ease of information access in the present age. However, consistent with the trend of low literacy rate is the participation rate. In 2007 study, 76 percent of the study respondents did not report ownership of any stock or stock related assets (van Rooij et al., 2011).
One of the key determinants of financial literacy is the level of education. With increasing education, financial literacy increase. However, the level of education does not imply complete interest in participation in the stock market. Households and individuals with high levels of education and financial literacy also exhibit low participation in the stock markets. This implies that there are other impediments to participation beyond financial literacy (van Rooij et al., 2011).
Cognitive abilities also affect individual preferences to invest in stock markets. As outlined earlier cognitive abilities relate to how individuals modify behaviors to react to or make decisions about different events. Individuals with high cognitive abilities shows greater confidence in their (objective and subjective) financial literacy. Because of their confidence, such individuals participate in the stock market. Individuals with low confidence keep away from the markets. Being confident about financial literacy increase the probability of participation in the stock market by approximately 20 percent (Xia, Wang, & Li, 2014). Additionally, the cognitive abilities define the risk preferences of individuals. Individuals with high literacy levels may still have low risk preferences therefore preferring not to participate in the stock market.
Financial literacy affects participation in two distinct ways. One, individuals may lack awareness about how to participate in the market. Due to lack of awareness (information asymmetry), households are less likely to participate. The second way literacy affects participation relates to rationalization or justification for participation. For individuals to participate, they need to understand how to measure the risks and benefits. However, because they lack sound financial literacy, they may not understand how their investments will yield a return. This forces them to remain in the traditional investment methods such as savings or loans for asset acquisition.
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Household participation in stock markets around the world has been observed to be very low. Similarly, financial literacy is also very low. The relation between literacy and participation drives the conclusion that participation will remain low until conscious efforts are made to improve the levels of financial literacy. This should involve schools, governments and the financial institutions as well. With growth in financial literacy there will also be growth in stock market participation. Such growth will widen the market unlocking the potential to make more gains from stock investment. Individuals should also take the initiative to educate themselves more on financial matters to increase their wealth and diversify the investments to minimize risks.
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