Once Burned, Twice Shy? Financial Literacy and Wealth Losses during the Financial Crisis

January 19, 2020

Once Burned, Twice Shy? Financial Literacy and Wealth Losses during the Financial Crisis
Tabea Bucher-Koenen, Michael Ziegelmeyer
Review of Finance, Volume 18, Issue 6, October 2014, Pages 2215–2246, https://doi.org/10.1093/rof/rft052

The financial downturn and economic crisis of 2007 and 2008 stretched financial institutions, politicians, and corporations to their limits. To what extent were private households affected? And how did they react to the shock? Even in “normal times,” financially illiterate households have difficulties managing their finances. How does this translate to times of financial turbulence? Do more sophisticated individuals manage to protect their investments from shocks? These questions are difficult to answer because individuals with higher levels of expertise are more likely to own risky assets such as stocks, whose values took the hardest hit in the course of the crisis. In addition to the loss that households incurred, we place our focus on whether households realized these losses by selling affected assets. The analysis proceeds in two steps. First, we study the effects of the financial crisis on households’ wealth; second, we examine investors’ reactions to losses.

At first glance, these results may appear only relevant in an ex post, “I told you so”, sense, in particular, as short-term asset returns tend to be highly unpredictable. In fact, though, our analysis improves the understanding of the patterns of stock market participation and how they are affected by a potentially traumatic event like the financial crisis. This involves long-term consequences on the composition of households’ portfolios. A central, stark result is that not all individuals are equally prone to shy away from the assets that burned them: Individuals with lower levels of financial literacy are more likely to react in this fashion—as a consequence, they fail to benefit from markets’ resurgence in the short run, and from the equity premium in the long run.

Our analysis is based on the SAVE-survey, a representative panel of German households that contains detailed information on financial and socioeconomic variables and measures of financial literacy. According to our data, 20.5% of households in Germany suffered financial losses due to the financial crisis and on average households lost about 2,562 Euros or 3.6% of their financial assets. Individuals with low levels of financial knowledge are less likely to experience losses in wealth due to the financial crisis since less knowledgeable individuals tend to avoid investing in risky assets. There is no effect of financial literacy on the size of the loss. However, households with lower levels of financial expertise were more likely to sell assets whose value had deteriorated. They made their losses permanent. Thus, individuals who experience severe financial downturns are not only less likely to invest in financial assets later in life (as shown by Malmendier and Nagel, 2011) but also – if they have invested – more likely to entirely turn their back on stock markets in times of crisis. Intriguingly, it is households with lower levels of financial sophistication that are more prone to react in this way than more informed investors. This asymmetry in the reactions of households potentially gives rise to serious consequences with respect to wealth accumulation and distribution.