VR Logo

Perils of Being Financially 'Literate'

Knowledgeable people are more likely to make poor investing decisions and form the majority of those ripped off by fraudsters

Laments about the lack of financial literacy are a common refrain whenever anyone discusses any financial regulatory issue. There is an explicit assumption that if only customers of financial products did not suffer from this condition of financial illiteracy, then they would make better choices with their income, savings and investments. It sounds logical, but is it actually true?

A few years back I had come across a study that had discovered the opposite. This 2006 study on investor fraud had been conducted in the U.S. by a non-profit called the FINRA Investor Education Foundation. The study learned that people who were ripped off by fraudulent investor schemes outscored those who hadn’t been by a “statistically significant” 27 percentage points when it came to financial literacy.

I couldn’t find the actual report on the web, but I had an ‘A-ha’ moment the instant I read about the findings. It jibed perfectly with my own anecdotal impressions of the kind of individuals who make the wrong investment and savings choices. How could this be? Why would knowledgeable people make poorer investment choices? There are two ways of modelling these conclusions. One of them simply boils down to the old saying, ‘a little knowledge is a dangerous thing’. Those who have a certain understanding of financial matters assume that they know it all and get too adventurous with their money. They become overconfident and actively seek out investments that appeal to their sense of being able to handle complexity. In truth, those who are pitching those dodgy investments can outsmart their partial financial literacy.

The other problem that this points to is deeper. It raises the question of what exactly is financial literacy. If the financially literate are poor investors, then the definition of financial literacy must be wrong. They must not actually be financially literate by a functional and outcome-driven definition of financial literacy. And that’s the real problem. I spend a good amount of time listening to people’s investment problems and answering their questions and, take it from me; this is not a solvable problem. More active selling of ever-more complex financial products is running way ahead of what customers can understand. It’s a sort of an arms race between complexity and understanding, with complexity pulling ahead by an ever-widening margin. It’s satisfying to say that financial literacy needs to be enhanced, but I doubt whether that can be done to an adequate degree.