Financial Illiteracy and Stock Market Participation: Evidence from the RAND American Life Panel

Financially unsophisticated consumers who consistently make sub-optimal financial decisions may suffer lasting consequences for long-term wealth accumulation and welfare. This paper focuses attention on a well-documented area of potentially suboptimal financial decision making: the lack of stock market participation. Using a broad-based assessment of financial literacy administered to a sample of older American respondents in the RAND American Life Panel (ALP), we use a novel strategy for establishing causation between stock-market related financial literacy and stock market participation, using knowledge of other financial topics as instrumental variables. We find that ignorance of stock market investment knowledge significantly reduces propensity to hold stocks. In particular, a decrease of one-standard deviation in the relevant measure suggests a decrease on the order of 10% in participation.