How investor financial literacy and investor confidence work together to increase stock market participation

October 18, 2022

Contact: Jon Meerdink (meerdink@umich.edu)

ANN ARBOR — A new paper finds that financial literacy and self-confidence both play significant roles in how people invest their money, affecting both their participation in certain investments and their willingness to invest at all.

Set for publication in the November issue of Economic Modeling, the paper used data from the 2019 Survey of Consumer Finances (SCF) to explore the relationship between investor financial literacy and self-confidence with the goal of determining which had a bigger impact on investor behavior. 

The paper finds that people with higher financial literacy are more likely to invest, but people with both high financial literacy and high confidence in the economy are more likely to take on somewhat riskier investments, creating more diverse portfolios as a result.

“There’s long been a bit of a puzzle about why participation rates in stock markets in the U.S., and around the world, really, are pretty low,” said Joanne Hsu, Director of the Survey of Consumers at the University of Michigan’s Institute for Social Research (ISR) and one of the paper’s four authors. “Nearly half of American households do not directly own stocks. So we were trying to understand to what extent does financial literacy play into that? To what extent does investor confidence, whether that’s confidence in your own ability to manage your finances or confidence in the economy, play into that as well?”

Other studies have previously demonstrated that financial literacy has a positive influence on stock market behavior; people who are more financially literate tend to invest at a higher rate. But it wasn’t clear whether it was financial knowledge or the feeling of being secure in one’s financial knowledge that affects investor behavior. This paper demonstrates that people with higher confidence in themselves and the economy tend to be more willing to spend on riskier investments like stocks rather than lower-risk investments like bonds.

“Confidence in the economy is much more influential for investing in the stock market than in the bond market,” said Hsu. “And that makes sense because bonds are less risky than stocks. Often you turn to the less risky assets if you think the economy is not doing well. So it was really heartening to find a very sensible result for confidence.”

The paper concludes by arguing that working to increase investor confidence, both in their own investment abilities and in the economy as a whole, could lead to greater economic health for families and individuals.

The study was conducted in collaboration with Andrej Cupák (National Bank of Slovakia and University of Economics in Bratislava), Pirmin Fessler (Oesterreichische Nationalbank), and Piotr R. Paradowski (Luxembourg Income Study (LIS) & Gdańsk University of Technology).

Read the paper in Economic Modelling via Science Direct.

See Joanne Hsu speak on Consumer Sentiment and Expectations in an Inflationary Environment in the next edition of the ISR Insights Speaker Series on Thursday, October 20, 2022.