Who Lost the Most? Financial Literacy, Cognitive Abilities and the Financial Crisis

The recent financial downturn and economic crisis provided a major challenge for financial institutions, politicians, and companies around the world. In this context, it is of major importance to analyse how private households were affected by the crisis, how they reacted to such a shock and what the long-term consequences will be. One central question is whether households with higher financial literacy were better at protecting themselves from the effects of the financial and economic crisis. This question, however, is not easily answered because more financially literate households are also more prone to own risky assets. Therefore, these households are more likely affected by financial losses as a consequence of the crisis. Hence, the aim of the analysis by Tabea Bucher-Koenen and Michael Ziegelmeyer is not only to examine who was hit by financial losses, but also to investigate how households reacted to the shock and whether they realized their losses for sure by selling assets which lost in value.

The analysis reveals that little more than 20% of households in Germany report to have suffered financial losses due to the financial crisis1. On average, households report a loss of € 2,560 or 3.6% of their financial assets. A comparison of simulated losses, based on households' portfolio composition at the end of 2007 and average returns of these assets during 2008, illustrates that the self-reported measures are relatively close to the simulated ones. These findings give rise to the assumption that, on average, households have a reasonable understanding of the effects of the financial crisis on their financial assets.

Ex ante, the relation between financial literacy and financial losses is not clear. On the one hand individuals with lower literacy and cognitive abilities are more prone to make mistakes; on the other hand they are more likely to stay out of risky asset markets. The analysis reveals that the second effect outweighs the first. Individuals with lower levels of financial knowledge and otherwise similar socio-demographic characteristics are less likely to have invested in the stock market and are therefore in general less likely to report losses in wealth due to the financial crisis. In contrast to their expectations, the two MEA researchers found that among households reporting losses those with higher financial literacy did not lose a smaller fraction of their assets. However, households with lower levels of financial literacy sold their assets which lost in value with a higher likelihood. This reaction of households with low financial literacy to short-term losses may have substantial long-term consequences for the distribution of wealth. It is very likely that these households did not participate in the profits during the recovery of the markets in 2009 and 2010. Additionally, these households will face lower rates of return in the long-term - especially if the negative experiences discourage them from future risky investments. According to estimations, the average annual consumption expenditures of stockholders are about 1.5 - 2% above those of households not participating at the stock market (cf. Cocco et al., 2005 and Mankiw and Zeldes, 1991).
 
_________________________________________________
1 In SAVE 2009 a special module of questions was added to the questionnaire, which investigates the impact of the financial and economic crisis on households. The analyses are based on the evaluation of answers of 2,012 households representative for Germany.

 

Further Information:
Who Lost the Most? Financial Literacy, Cognitive Abilities and the Financial Crisis
MEA Discussion Paper 234-11 Bucher-Koenen, Tabea; Ziegelmeyer, Michael
Picture: Sven Hoppe - Fotolia.com