Financial Literacy And Portfolio Diversification

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Executive Summary

In this paper the authors focus on poor financial literacy as one potential factor explaining lack of portfolio diversification. They first propose test-based indicators of financial literacy and document the extent of portfolio under-diversification. They find that measures of financial literacy are strongly correlated with the degree of portfolio diversification. They also compare the test-based degree of financial literacy with investors' self-assessment of their financial knowledge, and find only a weak relation between the two measures, an issue that has gained importance after the EU Markets in Financial Instruments Directive (MIFID) has required financial institutions to rate investors' financial sophistication through questionnaires.

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