It seems like it is a naturally human tendency for people to overestimate their abilities when it comes to what they consider mundane fields.
We all marvel at surfers tackling Tahiti’s famous break at Teahupoo, people conquering Mount Everest, or the intellect of Albert Einstein and Stephen Hawking. But when it comes to everyday life research shows most drivers believe they are above average. Of course that’s statistically impossible, but it doesn’t stop individual drivers overstating their abilities.
It seems driving is not the only important piece of everyday life where people overestimate their expertise.
New research from State Street Global Advisers (SSGA) shows that overconfidence abounds when it comes to financial knowledge.
In a new report, “Developing Financial Knowledge” SSGA says “when asked about their level of financial knowledge, nearly two-thirds of individual investors rated themselves as advanced — a clear disconnect from their actual literacy scores”.
But when asked a fairly simple, and basic, question about the differences between actively managed funds compared to indexed funds 72% of men and 57% of women claimed to know which were more expensive. But State Street says “only 15% of men and women actually responded correctly that active funds cost more”.
It may seem a small, perhaps, arcane point on which to make the case that people are overconfident when it comes to investing but SSGA says “the average financial literacy score of
investors globally is 61%, barely above a failing grade”.
In particular they noted “even high net worth individuals displayed dangerously low levels of financial literacy”.
That’s a particular indictment because “when asked about their level of financial knowledge, nearly two-thirds of investors rated themselves as advanced — a clear disconnect from their actual literacy scores” SSGA said.
It’s important because SSGA’s research also showed that the level of financial literacy impacted on people’s asset allocation decisions. That has the potential to impact long run returns because it tends to bias investment decisions toward cash and fixed income investments.
SSGA found that US investors with financial literacy scores above 70% had allocated, on average, 46% of their portfolios to equities. That’s 18 percentage points higher than the 28% allocated into equity investments by those who scored below 70%.
“And, the more financially literate group also held markedly less cash than lower-scoring investors” SSGA.
But it not just about asset allocation in normal markets. Coupled with naturally emotional responses financial literacy also impacts choice at times of market panic.
Behavioural psychology, finance, and economics academics who have studied human reactions know that we are, as a species, loss averse. That is losses loom larger than corresponding gains. The result is that fear of loss can make investors act in their short-term emotional interest but not their long-term financial interest.
Retail investors famously pulled record amounts out of equity funds during the worst part of the financial crisis in 2008, illustrating the well-documented tendency of individuals to respond far more strongly to losses than to gains. That same loss-aversion tendency also caused many retail investors to stay out of the market and miss the most rewarding part of the historic market rebound that started in early 2009.
But it seems even after what should have been a salutary lesson as investors missed the market bounce SSGA says “70% of women and 58% of men would consider moving to a more conservative investment strategy if their portfolio declined by more than 20% in a year. And a whopping 90% of those investors would make the change in less than three months”.
If the SSGA research shows anything it is that both the current holders of the world’s wealth and the beneficiaries of that wealth transfer of the next 30 years need to increase their financial literacy. If they do not there is a strong chance they will not meet their investment goals or be able to meet the needs of increased longevity.
That could be a financial disaster in later life.
Acquiring the capability to be more financially literate is especially poignant for Australians given our compulsory superannuation retirement savings system. It’s as important as learning to drive.