Improving financial literacy will increase savings rates and raise the level of equity exposure pension fund members are willing to take on, according to a US researcher from Wellesley College.
Presenting the findings from a paper he co-authored at a retirement conference hosted by Vienna Economic University (WU), Seth Neumuller argued that “large gains” to returns were still possible if the financial literacy of people in their 30s and 40s was improved.
Neumuller’s paper, ’Financial Sophistication and Portfolio Choice over the Life Cycle’, published together with Casey Rothschild in June this year, also examined how the older age groups had accrued sufficient assets to actually make investment choices.
However, he warned that encouraging “unsophisticated investors to save for retirement using tax incentives may create significant deadweight loss”, because it could encourage the wrong kind of saving patterns.
In his research, Neumuller blamed a lot of wrong investment choices on what he termed “meta-uncertainty”. “Less sophisticated investors get lower quality assets and are uncertain about which assets they get,” he noted.
As they were aware of this, it decreased their willingness to invest or they choose less risky assets.
His sample showed that more sophisticated investors had 36% more wealth by retirement and “enjoy 17% more consumption annually” than unsophisticated investors because of higher returns on their portfolios.
However, in in a later debate on the paper, David Robinson from the US National Bureau of Economic Research (NBER), cited his own research on people overestimating their financial literacy.
He agreed that meta-uncertainty lowered wealth through a reducution in market participation.
But in a survey he did on the networking platform LinkedIn in July 2015, he found people that had modest financial literature scores thought they were more educated than their ratings implied. “The level of meta-uncertainty is lost on these persons.”
For example, he found that people that overestimated their financial literacy were more likely to “get answers wrong than say they don’t know” and they also were more likely to reject financial advice.
Another factor influencing savings’ behaviour was the way information was displayed, according to Maya O. Shaton from the University of Chicago Booth School of Business.
She examined how the Israeli authorities decision to stop retirement funds displaying one-month returns had affected people’s choice in funds.
Since 2010, private retirement funds in Israel have only been allowed to display returns for a 12 months period or longer.
According to the research published in the paper “The Display of Information and Household Investment Behavior” (November 2014) the “allocation to riskier retirement funds by households increased after the regulatory change.
Overall, however, the trading volume decreased by approximately 38%.
“As 12-month returns are smoother these can impact households’ perception of losses and the retirement funds’ risk profile,” Shaton argued.
She added this “relatively low-cost” regulation was “less paternalistic than telling households what to do”.
Shaton stressed “failure to recognize the effect of the display of information on investors might lead to granting unwarranted power to the party disclosing information”.
The significance of investor choice for future wealth was underlined by findings from another paper by Javed Ahmed, Brad Barber and Terrance Odean entitled “Made Poorer by Choice” (2013).
The findings showed that almost all US workers selecting their own investment option in a private retirement account (PRA) were in the end worse off than those only getting money from the pay-as-you-go Social Security system.
Ahmed argued that investor choice was an “underappreciated, emergent risk in private alternatives to Social Security”.