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The
importance of Financial Literacy

“Compound
interest is the eighth wonder of the world. He, who understands it, earns it
… he who doesn’t, pays it…”-Albert Einstein

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One
of the first lessons we learn in Economics is that ‘Man has unlimited wants and
scarce resources’. For centuries the field of Economics has tried to solve this
puzzle. The debate on how the puzzle needs to be solved has continued but the
puzzle hasn’t changed. Economists try to solve this problem on a macro level.
They propose allocation of resources of the nation for its most efficient use.
At the same time an individual is solving this puzzle for his/her household. An
individual who runs a household faces two primary challenges related to his/her
finances. Firstly, as mentioned above the household as whole has certain needs
and wants which have to be fulfilled. For example monthly recurring
expenditures, children’s education, marriage expenses etc. The second challenge
he/she will be facing is how to meet sudden expenditures that happen in an
emergency situation. Now, how does he meet these challenges? To meet these
challenges he/she has manage his/her finances efficiently. The household has to
do some kind of ‘Financial Planning’. Here comes the need of financial
literacy. Before talking about financial literacy and benefits of financial
planning we have to take a look at the various definitions of Financial
Literacy.

1.
The Presidents Advisory Council on Financial Literacy (PACFL, 2008), convened
to “improve financial literacy among all Americans,” defines financial literacy
and financial education as follows: Financial literacy: the ability to use
knowledge and skills to manage financial resources effectively for a lifetime
of financial well-being. (Hung, Parker and Yoong, 2009)

2.
“Knowledge of basic financial concepts, such as the working of interest compounding,
the difference between nominal and real values, and the basics of risk diversification”
(Lusardi, 2008a, 2008b)

3.
Financial literacy is the ability to understand how money works: how someone makes,
manages and invests it, and also expends it (especially when one donates to charity)
to help others. (Christiana Mbazigwe).

Now
the question arises whether literacy is sufficient to meet these challenges? Financial
literacy is necessary but not a sufficient condition to safeguard against the
above mentioned challenges. The puzzle is solved only when the knowledge of
financial literacy can be of some help to the individual. In a country like
India where Financial Inclusion is the talk of hour we came to know that the
amount of research on the issue of Financial Literacy is very limited.

Financial
literacy is more important than ever in today’s world. Being aware of money
management, income, saving, and spending can equip our young people with
knowledge to fight fraud and take charge of their finances. We are living in an
age of unprecedented debt and people are destined to face challenging times
financially. It is imperative that educators begin to equip people with the
knowledge and skills to succeed as consumers in today’s global economy.
Teachers, administrators, parents, business owners, and community members need
to know the importance and value of Personal Finance literacy. Lusardi addresses
this problem in her paper ‘Financial Literacy: An Essential for Informed Consumer
Choice, 2008’, where she asks the question ‘Does Financial Literacy matter?’ She
writes “Retirement planning is a powerful predictor of wealth accumulation;
those who plan have more than double the wealth of those who have not done any
retirement planning. Financial Literacy matters for planning: Those who are
more financially knowledgeable are much more likely to have planned for
retirement. Even after accounting for demographic characteristics, financial
literacy continues to be an important determinant of planning.” She further
adds that ‘Those who were financially literate when young are more likely to
plan for retirement, showing that literacy that affects planning, has important
implication welfare and not the other way around.

There is widespread financial
illiteracy among the population, particularly among social demographic groups
like that of people with Low education, women etc. Lusardi, Mitchell and Curto
(2009) studied the level of financial literacy among the youth and found that less
than one-third of young adults possess basic knowledge of interest rates,
inflation and risk diversification. Young people are leaving school without the
basic skills to manage their personal financial affairs, putting them at a high
risk for not being able to plan responsibly for their financial future.”

Financial
literacy is strongly correlated with use of financial services, savings and
retirement planning. There is a clear positive correlation between income
levels and participation in financial planning. Higher income levels leads to
higher exposure towards financial markets and thus people belonging to this
class are introduced to various instruments in the markets. Adding to that
people become more financial aware as their income level increases. It can also
be argued that, to participate in markets like that stock market or mutual
funds an individual needs to save enough money every month or should have huge
lumps of money. But this is not the case. There are options like Systematic
Investment Planning or SIPs where an Investor can start investing with amount
as low as Rs.500 per month. So one can deduce from this that financial literacy
has not yet penetrated to groups with low levels of income. If there is no
education, the trust deficit will be a hindrance to people who want to increase
their wealth by investing in financial instruments.

Cole
and Shastry in their paper ‘Smart Money: The Effect of Education, Cognitive
Ability, and Financial Literacy on Financial Market Participation’, have argued
that cognitive ability increases participation in financial markets. They have
concluded that the level of education has a strong impact on level of
participation through personality, borrowing behaviour, discount rates, risk
aversion, influence of employees and neighbours. They highlighted the fact that
one year of schooling increases the probability of financial market
participation by 7-8%, holding other factors constant, including income. They
propose two reasons for this. Firstly, education affects cognitive ability and
then they have observed that higher levels of cognitive ability lead to greater
financial market participation. Second reason is that they feel that education
might affect financial behaviour including effects on personality, borrowing behaviour,
discount rates, risk-aversion and the influence of employers and neighbours. We
could see the effect of education on an individual’s personality. These effects
can also be traced down to kind of workplaces that he/she is working in. Better
workplaces expose an individual towards various instruments in the financial
market. This exposure automatically increases participation levels. The level
of financial literacy and participation is limited. To just get an estimate
about the level of penetration of financial literacy we can look at the number
of trading accounts. As on September 30, 2015 the number of Investor accounts
were 14,106,428. This is very small number compared to the 1.25 Billion
population of India. While only
53% of Indians had bank accounts against 79% in China till 2014 (as per World
Bank Gallup Global Findex Survey 2014), the gap has narrowed significantly after
the launch of Pradhan Mantri Jan Dhan Yojana, which has led to over 280 million
new accounts being added to the financial system (as of 5 April 2017, according
to government data). The launch of digital wallets, Universal Payments Interface (UPI)
and new-age commercial and payments banks have paved new ways for a less-cash
economy. According to RBI, the total number of digital transactions has
grown from over 419 million in November 2015 to 692 million in March 2017.

Lot
of work needs to be done in this area. At the same time one has to agree that
the efforts are being made from the regulators side to bring up these numbers.
For example the Reserve Bank of India launched an initiative in 2007 to
establish Financial Literacy and Credit Counselling Centres throughout the
country which would offer free financial education and counselling to urban and
rural populations. ‘Investor Awareness Programs’ is one more initiative that
has been started by institutions like SEBI, BSE, NSE, AMFI (Association of
Mutual Funds in India), Ministry of Finance. These programs have been
successful in two fronts. First is Frequency (Programs like these are happening
on a daily basis). Second is Attendance. Now the main concern that remains is
conversion. That is, how many people who attended these programs actually
started participating in financial markets? Majority of the people don’t know
about these kinds of programs. About a quarter of them have attended these but
didn’t bring what they learnt in these programs into practice. This shows that
although frequency and attendance in these programs is quite high penetration
and effectiveness are still concerns. We have seen that education and income
levels have a positive impact on participation. This can also become cyclical
in nature. The people who have higher income levels participate in financial
markets and increase their wealth. This helps the next generation of this class
to have better education levels and thus get jobs with higher levels of income.
So we can see that this has the potential to become cyclical in nature. While
Investor Education Programs and instruments like Systematic Investment Plans
(SIPs) have been of help to increase involvement of people from lower income
groups, much can done to improve the effectiveness of these programs. The
people with low education levels will remain at the lower levels unless there
is ‘big push’ given to them. This big push has to come in the form of financial
literacy and awareness.

As
stated in the Journal of Consumer Affairs, “. . . young people are leaving
school without the basic skills to manage their personal financial affairs,
putting them at a high risk for not being able to plan responsibly for their
financial future.” (Howlett, Kees, & Kemp, 2006, p. 240). In order to
obtain competence in financial literacy, consumers and/or students must
understand the problems faced in the marketplace. They must have the training
to discern the best way to protect them from becoming victims of financial
ignorance. This ignorance can be tempered through financial education.
Educating our future leaders about personal finance becomes a pressing issue. In
the long run, in an ever changing global economy the strength and health of our
economy will be determined by how well we educate our young people today.

 

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