Risk Taking, Diversification Behavior and Financial Literacy of Individual Investors

33 Pages Posted: 17 Oct 2012

See all articles by Elisa Cavezzali

Elisa Cavezzali

Ca Foscari University of Venice - Department of Management

Gloria Gardenal

Ca Foscari University of Venice - Department of Management

Ugo Rigoni

Ca Foscari University of Venice - Department of Management

Date Written: September 17, 2012

Abstract

This research investigates whether the financial literacy of individuals influences risk taking decisions and diversification behavior. This issue is relevant in that investors are increasingly in charge of their own financial security, but they have to deal with financial instruments whose increasing complexity often eventually prevents them from making conscious investment decisions.

Prior empirical evidence shows that people are unable to perform a “sophisticated” portfolio diversification: what they do is to split equally their wealth among the asset classes available, in a naïve way. We try to detect if the financial literacy is a driver of this kind of decisions.

By submitting a questionnaire to 200 American individuals, we find that financial literacy plays a role in risk taking decisions, positively affecting how much risk individuals are willing to take. Moreover, only those who are literate in terms of diversification select less risky portfolios; the others merely increase their risk exposure, without managing it. Consistently with the previous literature, the strategy of diversification adopted by the literate ones is mainly naïve. Instead, financial literacy turns out not being significant in explaining more sophisticated diversification strategies.

As financial literacy affects positively the amount of risk taken by individuals, but only partially the diversification strategies pursued, there might be a dangerous pitfall in today's financial education programs promoted by governments and regulators, which, though they make investors more aware of their investment decisions, they eventually push them to assume more risks than they are able to manage. Two possible ways to tackle this issue could be: 1) to boost the financial literacy of the investors so as to make them able to use all the investment techniques required by the standard theory. This, however, seems difficult to obtain; 2) to promote advisory activity among investors. This may help them to apply the diversification principle in a sophisticated way.

Keywords: risk taking, diversification behavior, financial literacy

JEL Classification: G02, G11

Suggested Citation

Cavezzali, Elisa and Gardenal, Gloria and Rigoni, Ugo, Risk Taking, Diversification Behavior and Financial Literacy of Individual Investors (September 17, 2012). Università Ca' Foscari Department of Management Venezia Working Paper No. 17/2012, Available at SSRN: https://ssrn.com/abstract=2162783

Elisa Cavezzali

Ca Foscari University of Venice - Department of Management ( email )

San Giobbe, Cannaregio 873
Venice, 30121
Italy

Gloria Gardenal (Contact Author)

Ca Foscari University of Venice - Department of Management ( email )

San Giobbe, Cannaregio 873
Venice, 30121
Italy

Ugo Rigoni

Ca Foscari University of Venice - Department of Management ( email )

San Giobbe, Cannaregio 873
Venice, 30121
Italy

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