Your Financial Knowledge is Probably Inadequate

I would never have imagined how much I overestimated the financial knowledge and skills of self-directed investors who manage their own stock portfolio. At least that was my conclusion a few days ago, after reading a study on the subject entitled Financial Knowledge and Rationality of Canadian Investors. That's why I've dedicated today's entire chronicle to this topic.

This study was conducted by Cécile Carpentier and Jean-Marc Suret, two finance professors from Université Laval. Although the study dates back to autumn 2011, I think its findings are still valid seven years later. Autonomous investors simply do not pass the test of financial knowledge and competence to venture into the jungle that is the stock market. In fact, they fail miserably. Only 5% of respondents scored 66% or higher.

Profile of Investors Responding to the Survey

In order to estimate knowledge and rationality of investors, an online survey was conducted among 1,814 people who independently manage personal equity portfolios. These people had previously fulfilled the conditions of admission; that is to hold shares of companies listed on the stock exchange and to be the main person responsible for decisions relating to their management. A survey composed of many questions was submitted to them. The first component aimed to verify their level of knowledge, while the second component aimed to verify the behavioral biases affecting their investment decisions.

About 50% of survey respondents were from Quebec and 50% were from Ontario. Almost 60% of these respondents were 55 or older, while just fewer than 10% were under 35 years of age. Two-thirds had a university level of education. Although the level of financial literacy is positively related to age and education level, the poor survey results show that experience and education are not a sufficiently large safeguard to counteract the lack of financial knowledge and skills.

Gaps in Financial Literacy

Here are some examples of financial literacy shortcomings, among many others that came out of the survey:

1. One in three investors is (erroneously) certain to get dividends into the future from a company that usually pays dividends. If a company as large as the US Wells Fargo Bank (WFC), which is also one of the most prestigious banks in the world, was forced to slash its dividend by 85% in 2009 (in the wake of the financial crisis), one can say that no company is in a position to guarantee its dividend.
2. More than 40% of survey respondents stated, erroneously of course, that the probability of a negative overall return on government bonds as a whole was 0%. From time to time, when interest rates rise, the annual yield on government bonds is negative. The level of probability of this happening is around 10%. The last time this occurred was in 2013.
3. 50% of respondents believed that holding less than 10 stocks from different sectors was enough to properly diversify a stock portfolio. The correct answer is that 10 to 20 stocks are needed, according to the author of this study. I agree with this range, provided that the investor is of high caliber. Otherwise, a portfolio of 20 to 30 stocks would, in my opinion, be preferable.

Finally, here is the survey question that most appealed to me:

You have a choice between a large company listed in the TSX 300 index that you do not know and a small, publicly traded company, whose product, management team and project you are very familiar with. Its sales are few million dollars. Would you say that investing in the small company is:

• Much less risky than investing the large one: 6% agree with this answer
• Less risky than investing the large one: 19% agree
• As risky as investing the large one: 34% agree
• More risky than investing the large one: 29% agree
• Much more risky than investing the large one: 6% agree
• I do not know: 6%

Which of these statements do you think is correct?

Autonomous Investors Overestimate Their Skills

Only 5% of investors surveyed scored more than 66% on the test. By extrapolating, could we say that about 95% of these investors will underperform on the stock market? I cannot say for sure, but I dare to venture that this is probably not far from the truth. By the way, the survey showed that only 20% of respondents felt that a systematic comparison of the performance of their portfolio with that of their benchmark index was a good practice to adopt to verify their performance as managers. The other 80% did so only occasionally or never.

Paradoxically, two-thirds of the survey respondents reported having good portfolio management knowledge, despite the fact that the vast majority of them failed the test. All things considered, this is not surprising since the majority of respondents do not even bother to compare their own performance with that of their benchmark. If they did, they would see the facts and have no choice but to acknowledge their low level of knowledge and skills in this area. Certainly, I had greatly overestimated the financial knowledge and skills of self-directed investors and this is certainly not solely attributable to the inexperience of Generation Y youth (18 to 34 years old), since they represent only 10% of all respondents. In light of this survey, the importance of a financial information and training platform, such as that of Hardbacon, makes perfect sense and appears to me to be more relevant today than ever before.

No one would dare to venture into the equatorial jungle wearing flip-flops. Yet, many autonomous investors venture into the stock market jungle just as poorly equipped. To be autonomous in investment is to depend on oneself for one's investment decisions. The least we can do is properly equip ourselves before we venture out, and knowledge is the first piece of equipment to offer.

Finally, the answer to the last question is that it is much more risky to invest in small business than in the large one, and 94% of respondents were, so to speak, wearing flip-flops in the jungle.