Financial Literacy and Investment Decision Making in Pakistan

Research Proposal

Submitted to: Dr Ibn e Hassan

Submitted by: Sana Batool

Financial Literacy and Investment Decision Making in Pakistan

Introduction

Due to the continuous introduction of new financial products and services, individuals’ active
participation in the financial market is now recognizable. However, the complexity of some of
these products has become an obstacle for the financially illiterate investors. Knowing the
importance of financial literacy policymakers around the world are also devising the programs to
literate the unsophisticated individual investors. But on the other hand, investors themselves are
also responsible for their financial well-being (Van Rooij, M., Lusardi, A., & Alessie, R., 2011).

Different people gave different definitions for financial literacy. There are some conceptual
definitions of the concept.

Source Conceptual Definitions

Hilgert, Hogarth, & Beverley (2003) Financial knowledge

FINRA (2003) “The understanding ordinary investors have of

market principles, instruments, organizations
andregulations” (p. 2).

Moore (2003) “Individuals are considered financially literate if

they are competent and can demonstrate they
have used knowledge they have learned.
Financial literacy cannot be measured directly so
proxies must be used. Literacy is obtained
through practical experience and active
integration of knowledge. As people become
more literate they become increasingly more
financially sophisticated and it is conjectured that
this may also mean that an individual may be
more competent” (p. 29).
National Council on Economic “Familiarity with basic economic principles,
Education (NCEE) (2005) knowledge about the U.S. economy, and
understanding of some key economic terms”
(p. 3).
Mandell (2007) “The ability to evaluate the new and complex
financial instruments and make informed
judgments in both choice of instruments and
extent of use that would be in their own best
long-run interests” (pp. 163-164).
Lusardi and Mitchell (2007c) “Familiarity with “the most basic economic
concepts needed to make sensible saving and
investment decisions” (p. 36).
Lusardi and Tufano (2008) Focus on debt literacy, a component of
financial literacy, defining it as “the ability to
make simple decisions regarding debt
contracts, in particular how one applies basic
knowledge about interest compounding,
measured in the context of everyday financial
choices” (p. 1).
ANZ Bank (2008), drawn from “The ability to make informed judgments and
Schagen (2007) to take effective decisions regarding the use
and management of money” (p. 1).
Lusardi (2008a, 2008b) “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” (p. 2).

The common thing among these definitions is they all are talking about the knowledge about the
basic economic or financial concepts. Even in many of the studies, financial literacy is being
measured on the basis of the common financial terms as mentioned by the Lusardi in his
definition (Van Rooij, M., Lusardi, A., & Alessie, R., 2011, Lusardi and Mitchell, 2007a, 2008;
National Council on Economic Education (NCEE), 2005; Hilgert, Hogarth, and Beverly, 2003).
In Pakistan the concept of financial literacy is defined similar to others like the basic the
understanding of the finance concepts like profit, interest and bank (Pakistan microfinance
network report for World Bank, 2012).

From the existing studies, it is evident that people possess little knowledge even about the basic
financial concepts described in the above mentioned definition (Xu, L., & Zia, B., 2012, Van
Rooij, M., Lusardi, A., & Alessie, R., 2011, Lusardi and Mitchell, 2007a, 2008; National Council
on Economic Education (NCEE), 2005; Hilgert, Hogarth, and Beverly, 2003). While the
knowledge level about the more advanced financial concepts, like difference between bonds and
stocks, the working of mutual funds, and basic asset pricing is even more alarming (Annamaria
Lusardi, 2008). This lack of knowledge leads them to some chronic mistakes that are irreversible
too. Unsophisticated financial decisions may have insignificant impact in short term but in long
term they may result in crucial financial problems (Lusardi and Mitchell, 2007).

Studies also provide evidence that the people who are financial illiterate are less likely to make
financial decisions (Lusardi and Mitchell, 2007) and hence reluctant to get benefit from the
innovative financial products. Moreover, most of the research in this topic is done in order to
determine the level and the extent to which people are financially illiterate. Debate is still going
on about the role of financial literacy in financial decision making because the gap in the
knowledge persists about the relationship among the financial literacy and behavior (Hung, A.,
Parker, A. M., & Yoong, J., 2009). Despite this long term debate still the existing studies gave
less importance to the most important question that how people acquire financial literacy
(Lusardi, A., & Mitchell, O. S., 2013). But the researchers examined the relationship between
financial literacy and investment decision (Delavande, Rohwedder, and Willis 2008; Jappelli and
Padula 2013; and Lusardi, Michaud, and Mitchell 2013). So the literature suggests some
cautionary lessons that are gained from subprime mortgage experience have increased the
significance of this study at large. Firstly, poor financial decisions due to the lack of financial
knowledge are now widespread phenomena. Secondly, such glitches remain unobserved until
they result in financial crisis. Thirdly, the systematic effects and the resulted cost are
nevertheless substantial.

So in Pakistan, financial literacy is being measured in a finance survey conducted in 2008.

According to the findings of this study financial literacy is highest in the province of Punjab and
AJK while the situation is critical in Balochistan and KPK. Study also reveals that the situation is
more critical in rural areas and particularly among the females.

Research Problem
Through the literature review, we got to know that people lack in financial literacy and they
differ in their level of financial sophistication (Lusardi and Mitchell, 2010). Finance survey in
Pakistan considered the people as financially literate who have just heard about the basic finance
concepts. They haven’t mentioned the level of financial literacy that if people are financially
literate then what is the level of their financial literacy. Either they have just understanding about
the basic concepts or they know about the more advance financial concepts? So our study will be
able to fill the gap. Due to lack of financial literacy and low level of financial literacy, people use
to make chronic financial mistakes. On the other hand, the ratio of financially illiterate people
making investment decision is also significant. So it’s an important matter to consider that how
do the financially illiterate people make financial decisions and what kind of information
influences their decision.

Objectives

Keeping in view the above discussion our main objectives of this study are:

 To determine the different levels financial sophistication in the potential investors of

Pakistan
 To dig out the decision making behavior of the financially illiterate people
  To determine how the different sources of financial information can influence the
decision making

Literature Review

We are having a very little number of studies that provide information on financial literacy and
the constructs of financial decision making like saving and investment decisions, portfolio choice
and planning (Van Rooij, M., Lusardi, A., & Alessie, R., 2011). To overcome the problem
occurring because of insufficient data, Lusardi and Mitchell (2008) developed a module for
health and retirement study in 2004. The aim was to assess the knowledge about three basic
financial concepts compulsory for every individual who is going to make financial decision.
They presented their findings that financial illiteracy is common among the different groups of
population. Lusardi, A., & Mitchelli, O. (2007) make a thoughtful contribution to the existing
literature that potential investors are simply unfamiliar with the basic economic concepts
compulsory for utilitarian decision making. Enlarged level of financial unsophistication is also
described in studies on smaller groups (Agnew and Szykman, 2005; Bernheim, 1995, 1998;
Mandell, 2004). Researches carried out by the Organisation for Economic Co- operation and
Development (OECD) (2005) and Lusardi and Mitchell (2007b) provide the evidence that
financial illiteracy is widespread in developed countries as well.

Bernheim (1995, 1998) was among the researchers who first ever pointed out that common
people are not even able to make very simple financial decisions. Formerly, financial literacy
was found to be related to the different types of financial behaviors. For illustration, advanced
levels of financial literacy are associated with proficient money management (Hilgert, Hogarth,
& Beverly, 2003). While unsophisticated financial investors are more likely to make decisions
with uncomplimentary terms (Gerardi, Goette, & Meier, 2010; Miles, 2004) and also go for the
refinancing strategy when interest rates decline (Campbell, 2006). People having a lesser amount
of financial knowledge use to have more issues with debt financing (Lusardi and Tufano, 2009)
and use to have lesser participation in financial market (van Rooij, Lusardi, and Alessie , 2007).
Similarly, financial illiterate people use to hold undiversified portfolios more often (Calvet,
Campbell, & Sodini, (2009) and ignore the stock market trends completely (Van Rooij, M.,
Lusardi, A., & Alessie, R. (2011); Christelis, Jappelli, & Padula, 2010; Kimball & Shumway,
2006; Vissing-Jorgensen, 2004). Studies also provide evidence that even the potential investors
don’t go for the planning (Lusardi, 1999, 2003; Lusardi & Mitchell, 2006, 2007b).

In recent studies, Bernheim, Garrett, and Maki (2001) and Bernheim and Garrett (2003) also
witnessed that financially sophisticated investors are more likely to make bold investment
decisions. It is also evident from the study of Agarwal, Driscoll, Gabaix, and Laibson (2009) that
financial illiteracy is more common among the specified groups of young and elderly people.
This is actually the alarming facts. And the most critical argument is that people remain
unconcerned about getting financial knowledge until they face crisis. But in a research that was
conducted on credit card usage, 84% young people accepted that they need more financial
education and 64% were those who demanded a financial management course in high school
while 40% students asked for financial education in college (Sallie Mae, 2009). Meanwhile,
financial literacy has proved to be a key module for efficient decision making and particularly
young people have lust for financial education (Lusardi, A., Mitchell, O. S., & Curto, V., 2010).

Succeeding the study of Lusardi (1999), many studies argue that the employees are not having
any plan for their retirement (Ameriks et al. 2003, Hurst, 2003). While Gustman and Steinmeier,
(2004) argues that workers are not even aware of their source of income. Although most of the
studies conducted are US based but researches in other countries also presented the similar
results. Problem with the existing literature on financial literacy is that they provide little or no
information on the other important economic outcomes like sources of income and saving
patterns. In this study we are going to overcome this problem by collecting the data about the
sources of income of the investors and also the sources of information available. In addition to
this, we will try to solve the puzzle that people who are financially literate don’t invest in stocks,
a problem mentioned by Campbell (2006). Constantinides, Donaldson, and Mehra ( 2002) gave
their argument that young people don’t invest because they don’t have a well-established source
of income. Other studies incorporated some different reasons of not investing like trust and
culture (Guiso, Sapienza, and Zingales, 2008) while according to Hong, Kubik, and Stein, 2004;
Brown, Ivkovic, Smith, and Weisbenner (2008) peers and neighbors also do influence our
decision of making investment. Hitherto many researchers also blame the limited numeracy,
intelligence quotient and cognitive ability as the obstacle in investing ability (Christelis, Jappelli,
and Padula, 2010; Kezdi and Willis, 2008; Grinblatt, Keloharju, and Linnainmaa, 2007) along
with lack of awareness about the different kinds of assets (Guiso and Jappelli, 2005).
Methodology

Financial decision making is not a tranquil phenomena but it involves various important factors
that influence the investment decision like interest rates, inflation and financial markets’
behavior. Fewer researches are being conducted in order to assess how people make investment
decision, how do they deal with the problems they face while making the decision, do they have
enough information necessary to make financial decision and what is the level financial
sophistication. All these topics are worth considering while doing the research. So as our main
task is to measure the financial literacy among people so we going to formulate a module on
planning and financial literacy to measure them quantitatively for 2004 HRS. The module
includes two sets of questions.

These advance literacy questions will assess the different level of sophistication. After gathering
the data, simple factor analysis will be performed in order to do quantitative analysis to
determine the different levels of financial sophistication as done by Lusardi and Mitchell (2010).
This is accomplishing our first objective. In order to achieve our other three objectives we will
adopt qualitative method by interviewing different group of people in order to judge their
decision making behavior on the basis of their financial knowledge. So the overall methodology
of this study is mixed methodology as it is defined by the Greene (2007) as multiple ways of
hearing and seeing. Our unit of analysis will be the investors in NIT. Questionnaires will get
filled from the financially literate investors and interviews will be conducted from the people
who are financially illiterate.

The ontology of the methodology is subjective as well as objective. Because we are going to
measure financial literacy quantitatively which is an objective approach while in order to
measure the behavior of financially illiterate people, we will use qualitative method which is a
subjective approach.
Contribution

The practical contribution of this study is we will be able to determine the different levels of
financial sophistication in the potential investors of Pakistan that is helpful for the policy makers
to devise programs to enhance financial literacy. Further the governor of the state bank of
Pakistan mentioned in his statement for the newsletter of state bank of Pakistan 2015 that the
financial literacy programs that were being devised in 2012 can’t help them out to improve the
financial literacy. This study will help them to make the improvements in their existing
programs. Secondly, the theoretical implication of the study is, we will be able to provide
information about if people are financially illiterate, then how do they make decisions of
investing? Also we will be able to determine that how the different sources of financial
information available can influence the decision making. This will be helpful for the potential
investors that which type of information is helpful for them for investing.

Research Limitations

The limitations of this study are such that the financial literacy is not the only obstacle in the way
of investment decision making. Low income and the overall low literacy rate along with many
others are also the hindrances. While the studying the behavior of financially illiterates who are
making investment decisions is not enough. Digging out the behavior of financially literate
people who are reluctant to make investments is of equal importance because their participation
in the financial market is worthy.

References

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participation. Journal of Financial Economics, 101(2), 449-472. Financial literacy and stock
market participation. Journal of Financial Economics, 101(2), 449-472.

Xu, L., & Zia, B. (2012). Financial literacy around the world: an overview of the evidence with
practical suggestions for the way forward. World Bank Policy Research Working Paper, (6107).

Huston, S. J. (2010). Measuring financial literacy. Journal of Consumer Affairs, 44(2), 296-316.
Hung, A., Parker, A. M., & Yoong, J. (2009). Defining and measuring financial literacy.

Lusardi, A., & Mitchell, O. S. (2013). The economic importance of financial literacy: Theory
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Lusardi, A., Mitchell, O. S., & Curto, V. (2010). Financial literacy among the young. Journal of
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Lusardi, A., & Mitchell, O. S. (2011). Financial literacy around the world: an overview. Journal
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literacy and cognitive resources. Michigan Retirement Research Center Research Paper, (2008-
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Brown, J. R., Ivković, Z., Smith, P. A., & Weisbenner, S. (2008). Neighbors matter: Causal
community effects and stock market participation. The Journal of Finance, 63(3), 1509-1531.

Calvet, L. E., Campbell, J. Y., & Sodini, P. (2009). Measuring the financial sophistication of
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Disappear with Wealth? Evidence from Expectations and Actions. In NBER Macroeconomics
Annual 2003, Volume 18 (pp. 139-208). The MIT Press.

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Appendix A

Basic literacy questions

1) Numeracy: 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?

(i) More than $102

(ii) Exactly $102

(iii) Less than $102

(iv) Do not know

(v) Refusal.

2) Interest compounding: Suppose you had $100 in a savings account and the interest rate is
20% per year and you never withdraw money or interest payments. After 5 years, how much
would you have on this account in total?

(i) More than $200

(ii) Exactly $200

(iii) Less than $200

(iv) Do not know

(v) Refusal.

3) Inflation: 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?

(i) More than today

(ii) Exactly the same

(iii) Less than today

(iv) Do not know

(v) Refusal.

4) Time value of money: Assume a friend inherits $10,000 today and his sibling inherits $10,000
3 years from now. Who is richer because of the inheritance?

(i) My friend

(ii) His sibling

(iii) They are equally rich

(iv) Do not know

(v) Refusal.

5) Money illusion: Suppose that in the year 2010, your income has doubled and prices of all
goods have doubled too. In 2010, how much will you be able to buy with your income?

(i) More than today

(ii) The same

(iii) Less than today

(iv) Do not know

(v) Refusal.

These questions will help us to measure the basic numeracy, inflation, interest compounding
time value of money and money illusion. Second group of questions will assess the more
advanced financial information and will measure difference between stocks and bonds, the
function of the stock market, the workings of risk diversification, and the relationship between
bond prices and interest rates. These are the questions that were being used in the module in HRS
and in other studies on financial literacy.

Advanced literacy questions

(6) Which of the following statements describes the main function of the stock market?
(i) The stock market helps to predict stock earnings
(ii) The stock market results in an increase in the price of stocks
(iii) The stock market brings people who want to buy stocks together with those who want to sell
stocks
(iv) None of the above
(v) Do not know
(vi) Refusal

(7) Which of the following statements is correct? If somebody buys the stock of firm B in the
stock market
(i) He owns a part of firm B
(ii) He has lent money to firm B
(iii) He is liable for firm B’s debts
(iv) None of the above
(v)Do not know
(vi) Refusal

(8) Which of the following statements is correct?

(i) Once one invests in a mutual fund, one cannot withdraw the money in the first year
(ii) Mutual funds can invest in several assets, for example invest in both stocks and bonds
(iii) Mutual funds pay a guaranteed rate of return which depends on their past performance
(iv) None of the above
(v) Do not know
(vi) Refusal

(9) Which of the following statements is correct? If somebody buys a bond of firm B
(i) He owns a part of firm B
(ii) He has lent money to firm B
(iii) He is liable for firm B’s debts
(iv) None of the above
(v) Do not know
(vi) Refusal.

(10) Considering a long time period (for example10 or 20years), which asset normally gives the
highest return?
(i) Savings accounts
(ii)Bonds
(iii) Stocks
(iv)Do not know
(vi)Refusal.

(11) Normally, which asset displays the highest fluctuations overtime?

(i)Savings accounts
(ii) Bonds
(iii)Stocks
(iv) Do not know
(v) Refusal.

(12) When an investor spreads his money among different assets, does the risk of losing money:
(i) Increase
(ii) Decrease
(iii) Stay the same
(iv) Do not know
(v) Refusal.

(13) If you buy a10-yearbond,it means you cannot sell it after 5 years without incurring a major
penalty. True or false?
(i) True
(ii) False
(iii) Do not know
(iv) Refusal.

(14) Stocks are normally riskier than bonds. True or false?

(i)True
(ii)False
(iii) Do not know
(iv) Refusal.

(15) Buying a company stock usually provides a safer return than a stock mutual fund. True or
false?
(i) True
(ii) False
(iii) Do not know
(iv)Refusal.

(16) If the interest rate falls, what should happen to bond prices?
(i) Rise
(ii)Fall
(iii)Stay the same
(iv) None of the above
(v)Do not know
(vi) Refusal.