Do consumers understand the risks associated with different ways of saving?

• Context
• The study
• Key findings
• Points to consider

Context

Consumers can save in several different ways, for example putting money in a bank account, investing in the stock market and buying property. It seems reasonable to assume that most people want their savings to grow as fast as possible, without suffering big swings in value. The problem is that no one knows for certain what will happen to interest rates, stock markets or house prices in the future, which makes saving decisions hard. It also means that what people think will happen – their subjective expectations – will be a key driver of saving decisions. For instance, several studies show that having higher stock market return expectations is associated with higher stock ownership. And whether such subjective (and not necessarily well-informed) expectations are reasonable may be an important decisive factor in whether consumers save in ways that are best for them and meet their saving goals.

This research paper explores whether consumers are able to assess uncertainty about future returns (based upon the assumption that people who are, are more likely to make good savings decisions).

The study

This study used results from the FCA’s 2021 Financial Lives survey (with analysis by Royal Holloway, LMU Munich and ifo Institute), as well as Financial Lives 2020 survey data. The latter included a set of questions based around interest rates on savings accounts, and about housing and stock market returns. The results were weighted to be representative of all UK adults.

The research questions explored were:

• Are consumers able to make a reasonable assessment of the returns associated with different ways of saving?
• Do they understand that outcomes are uncertain and that some ways of saving are riskier than others, with a greater chance of falls in value?

Respondents were asked to assign probabilities to a range of possible future outcomes. For example, the percent chance that a stock market investment will have gone down by 10% a year from now. The ability of respondents to respond, and their demographics, are reported. The authors also consider the potential link between financial vulnerability and the ability to answer probabilistic return questions.

Key findings

Ability to make probabilistic assessments

Overall, the researchers found that 73% of the UK adult population could make probabilistic assessments.

• 52% of these adults demonstrate a high degree of financial sophistication in terms of knowing about past returns, understanding relative returns and riskiness and forming reasonable beliefs about future asset returns.
• Another 40% show a moderate degree of financial sophistication.
• This means that, overall, 38% of consumers are able to assign probabilities to future outcomes and show a high degree of financial sophistication.
• 29% of consumers are able to assign probabilities and show a moderate degree of financial sophistication.
• The remaining 33% of consumers are either not able to assign probabilities or show a low degree of financial sophistication.

Characteristics and demographic differences

• UK adults who are not able to assign probabilities to future returns are more likely to be female (33% vs 20%), and to have left school without academic qualifications (56% vs 16% of those with higher education); and to be individuals with low socio-economic status (as measured by being unemployed or by having low levels of savings).
• Consumers with characteristics of vulnerability (e.g. poor numeracy skills or low knowledge or confidence in managing finances) are more likely not to be able to answer probabilistic questions than consumers who do not show characteristics of vulnerability (35% vs 20%).

Financial sophistication model

Among the subgroup of consumers who can assign probabilities to future returns, the research investigates how knowledgeable they are about past financial developments, and how reasonable their beliefs about future asset returns are – given what is known about how different financial markets work. The researchers assert that people who can conceptualise the uncertainty of future returns in a financially sophisticated manner will be better equipped to make sound financial decisions. This financial sophistication modelling shows:

• 52% of those who answered the probabilistic return questions also display high financial sophistication, defined as satisfying at least five of the seven criteria.
• A further 40% display moderate financial sophistication (fulfilling three or four of the criteria).
• Fewer than one in ten (8%) display low financial sophistication (two or less).

Points to consider

• Methodological strengths/weaknesses: The research paper notes that most of the data were gathered before the stock market and house price fluctuations that occurred during the Covid-19 pandemic. This is particularly relevant given that the research was based in part on respondents’ ability to predict future outcomes based on past performance.
• Generalisability/ transferability: The topic of financial capability is enduringly relevant and this study offers a new approach to understanding consumer ability to assess potential returns associated with different ways of investing/saving.
• Relevance: The topic of financial capability is enduringly relevant and this study offers a new approach to understanding consumer ability to assess potential returns associated with different ways of investing/saving.
• Applicability: The topic of financial capability is enduringly relevant and this study offers a new approach to understanding consumer ability to assess potential returns associated with different ways of investing/saving.