Written by Therese Faessler.
Broadly speaking, being financially literate is the ability to understand one’s current financial situation and plan for one’s financial future. Financial literacy is key because it brings financial inclusion. And financial inclusion has a positive impact, a ripple effect, not only on the individual, and the family, but also on companies, the economy, the country and society at large.
The varying degrees of financial literacy
Financial literacy ranges from the ability to understand and live within one’s means today to having a concrete plan on how to allocate one’s income for an uncertain future and a long life.
Being financially literate means having the knowledge, skills, and discipline to manage one’s income and wealth wisely. It is not only about knowledge, but more importantly discipline and implementation.
Recently, the Organization for Economic Cooperation and Development and the International Network on Financial Education (OECD/INFE) (2016) described financial literacy as “… [a] combination of awareness, knowledge, skill, attitude and behavior necessary to make sound financial decisions and ultimately achieve individual financial well-being.”
With this definition of financial literacy, it is obvious that the reach of the term is not only about knowledge but also skills, attitudes, and actual behavior.
How do we measure financial literacy?
In recent empirical studies the measurement of financial literacy is based only on one of these dimensions namely, financial knowledge, using the three standard questions proposed by Lusardi and Mitchell (2007).
Annamaria Lusardi is the global leader in financial literacy. She has conducted research on financial literacy for over 20 years, written over 90 articles and published two books.
The three standard questions she uses to measure financial literacy are:
- Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
- More than $102
- Exactly $102
- Less than $102
- Don’t know
- Refuse to answer
- Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
- More than today
- Exactly the same
- Less than today
- Don’t know
- Refuse to answer
- Please tell me whether this statement is true or false.
‘Buying a single company’s stock usually provides a safer return than a stock mutual fund’.
- Don’t know
- Refuse to answer
Why is financial literacy important?
Financial literacy is important because it is the prerequisite for financial inclusion.
Financial inclusion is an economic system in which all individuals can access and use financial services that improve their well-being. This definition goes beyond the three standard questions to measure financial literacy because it includes the ability to access and use, and not “only” understand that the possibility exists.
Financial inclusion is an important determinant of economic growth and poverty reduction (World Bank 2018). Households that are financially included are able to increase savings, invest in education, launch businesses, empower women, and improve health outcomes. Financial literacy plays an important role in furthering financial inclusion according to Grohmann et al. (2018) based on data from the S&P global financial literature survey.
Financial literacy and financial inclusion can create a ripple effect which affects not only individuals, but also families, countries, companies, economies, and societies.
The effect of financial inclusion on individuals
According to Bialowolski et al. (2023) individual financial literacy has a real impact on individual overall well-being, including health. Sherraden (2013) concluded that financial capability, the combination of the ability to act and the opportunity to act, may affect health-related risk through for example the ability to manage financial stress, avoid material hardships, gain access to medical care, and increase healthy behaviors, such as affording gym memberships and fresh vegetables and fruits.
Capital creation and investing have an impact on individual financial futures. Xu et al. (2023) using New Zealand Household Economic Survey (HES) 2018 data reported on the importance of post-retirement financial market participation in the enhancement of retirees’ financial well-being. They concluded that retirees who participate in the financial market enjoy a 78% increase in overall annuitized net wealth. Another significant finding is that there was a substantial 154% increase if government pensions were excluded from calculations of annuitized net wealth.
The effect of financial inclusion on families
Financial literacy is significantly important for families, in particular parents, as the cost of having children is high and new parents face various financial challenges. Throughout their children’s lives, parents will be subject to new financial challenges including day care, education, medical care, and other expenses. According to Hällsten & Pfeffer (2017), there is a direct positive correlation between parents’ wealth and their children’s education, future income, and wealth.
The effect of financial inclusion on countries
Financial literacy also has an effect on countries, as it affects citizens’ decisions and financial behavior. For example, financial literacy has been proven to affect both saving and investment behavior and debt management and borrowing practices. Empirically, financially savvy people are more likely to accumulate wealth (Lusardi and Mitchell, 2014).
There are several explanations for why higher financial literacy translates into greater wealth. Several studies have documented that those who have higher financial literacy are more likely to plan for retirement, probably because they are more likely to appreciate the power of interest compounding and are better able to make the necessary calculations.
This financial independence has a significant effect on national social welfare programs. A financial literate population has greater financial stability and a lower risk of financial hardship. This contributes to the overall economic stability of a country.
Regarding retirement planning, a financially literate population reduces the burden on the government to provide financial support to retirees. Financial literacy promotes entrepreneurship and innovation by providing individuals with the knowledge and skills needed to start, run a sustainable business, which in turn promotes national economic growth.
Countries with a financially literate workforce, especially regarding stock market participation rates, are more competitive on the global stage. Moshirian et al in their paper on “Stock market liberalization and innovation” found that in a sample of 20 economies countries liberalizing their stock markets exhibit a higher level of innovation output after liberalization and that this effect is disproportionately stronger in more innovative industries. Countries with a financially literate workforce are more competitive on the global stage. They can attract foreign investment, engage in international trade, and adapt to changing global economic conditions more effectively.
The effect of financial inclusion on companies
Financial literacy, in particular investing, has an impact on the liquidity of companies. Financial literacy includes capital creation by way of investments. Retail investors have an impact on the liquidity of companies, especially SMEs. In their study, Kian-Ping Lim, Wei Liu, Yee-Ee Chia (2023) found that the liquidity of SMEs improves considerably when retail shareholders hold stocks of companies that they are familiar with or have knowledge of.
Financially literate individuals are more likely to participate in capital markets, such as stocks and bonds. This can lead to increased capital formation in the country, which can support economic development, innovation, and job creation.
The effect of financial inclusion on economies and society at large
There are consequences of financial literacy on economies and society at large too. Financial literacy can help bridge the wealth gap by providing individuals with the knowledge and tools to build wealth and improve their financial situations. This can contribute to a more equitable distribution of income and wealth within a society.
Stock market participation affects both wealth and income inequality in various ways. Agarwal et al. (2022) found that the lack of stock market participation affects firms’ ability to raise capital through equity markets. If the demand for stocks is lower during periods of high uncertainty, then it is costlier for firms to raise capital. This, in turn, can worsen or slow down recovery from economic recessions, since periods of high political uncertainty and economic downturns tend to coincide. Recessions increase wealth and income inequality through savings gaps and higher unemployment rates of those worse off.
Being financially literate is therefore good for everyone
As we have seen, financial literacy is more than just knowledge; it encompasses skills, attitudes, and behaviors, playing a vital role in financial inclusion. Developing financial literacy helps to increase individuals’ ability to make sound financial decisions. Financially literate individuals will contribute to a more equitable distribution of income and wealth within society, ultimately promoting economic resilience. The impact of financial literacy extends from individual well-being to family prosperity and national economic stability.
In a next article we will describe the framework and the components of financial literacy, more specifically income, saving and budgeting, debt management, insuring and investing. We will see that there is an order to these components: it all starts with income. Without income, there is nothing to save or budget. Without savings, no debt should be taken on, there is no need for insurance and there is no possibility to invest.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of the Swiss Finance + Technology Association.
Therese Faessler is an active member of the Swiss Finance + Technology Association and serves as Head of Financial Literacy.
She is a strong, global proponent of Financial Literacy and works as an associate at the Swiss National Bank’s educational program. Her goal is to increase financial literacy in individuals as to trigger the ripples and shrink wealth gaps.
She manages a website, invested.ch, which she uses to teach financial literacy at Swiss high schools.