Overview – Investing and Financial Literacy: An Interesting Dynamic
Financial literacy is a hot topic year-round. It’s safe to say that money ranks high in our list of “most important things”, so it’s no surprise that people are always looking for new ways to better manage their personal finances.
Many variables contribute to a person’s level of financial literacy, and the point of this article isn’t to discuss (or speculate) what those variables are.
I’m sure most people will agree that investing, undoubtedly, is a major element of financial literacy. Even if you don’t have grand dreams of becoming very wealthy, investing can provide people with the financial stability they need today and for many years to come.
If that’s the case, then how are the two related? Does one precede the other, can both be developed at the same time, or is there some other approach?
What is Financial Literacy, Anyways?
Before we continue this discussion, I feel it’s appropriate to first define “financial literacy”.
There are hundreds, if not thousands, of definitions for financial literacy. These definitions range from very simple to very complex, and each have their own nuances to help people understand it in their own way.
Personally, I define financial literacy as:
“The skills, knowledge, and ways of thinking needed to help individuals make prudent financial decisions today and for the rest of their lives.”
Just as there are countless definitions of financial literacy, there are also countless variables that contribute to a person’s level of financial literacy.
Responsible use of credit, buying a car, buying a house, taking out a loan, the importance of saving, paying taxes, investing: the list goes on almost endlessly. There already exists mountains of material regarding financial literacy, and an article post won’t do justice to this extremely broad topic.
Because the financial landscape changes almost every day, it’s no surprise that definitions of financial literacy are subject to frequent change.
No matter how many times the definition of “financial literacy” is modified, the underlying definition will always stay the same – trying to understand the relationship between people and finances.
So, this brings us back to our main question: how are investing and financial literacy related to one another?
What Comes First: Financial Skills or Investing Knowledge?
You’re probably familiar with the famous “chicken or the egg” paradox. If an egg came first, this implies that a chicken had to first lay the egg. If a chicken comes first, this means that it first hatched from an egg.
A similar observation can be made when studying the relationship between financial literacy and investing: do you learn how to invest by becoming more financially literate, or is financial know-how a by-product of investment study?
In my experience and through my own observations, both scenarios are equally valid. Let’s explore these scenarios further.
Scenario 1: Learning to Invest After Becoming More Financially Literate
This is the path I see many people take, especially young people.
In the past, I consulted an Edmonton-based startup on how to improve its financial literacy curriculum. Their curriculum included what I more or less expected: credit, taxes, budgeting, and investing.
Based on this experience and the financial literacy content I’ve come across through the years, it’s not surprising that this scenario, that is, learning to invest after developing basic financial knowledge and skills first, is so common.
Financial illiteracy remains a major problem in Canada and the U.S. A report published by Calgary-based professional service firm MNP found that only 15% of Canadians believe they have strong financial skills. In the U.S, more than 50% of adults become anxious when thinking about personal finances.
With these statistics in mind, it’s only natural for people who are concerned about their lack of financial knowledge to try and address that weakness. Assuming they attend a typical personal finance course, it’s only a matter of time before they hear about investing.
If someone has minimal financial knowledge, then it’s very unlikely that they’ve heard about investing before (at best, they probably have heard the word before).
So, for some people, they only learn about investing not because they want to become investors, but because they want to improve their overall financial health, and investing happens to be one of the elements that will help them do that.
Scenario 2: Improving Your Financial Literacy by Studying How to Invest
Although this scenario seems unlikely, or at least not as popular, I know it exists because this is what I went through. I knew about investing and was interested in it before I studied financial literacy in-depth.
One of the first things I learned about investing is that you can’t invest if you have insufficient capital to work with. This makes sense: the whole point of investing is to put money down today with the hope of getting more in the future.
Sure, you can technically start investing with any amount of money, but any returns in the form of capital appreciation or dividends will be minuscule. If you want your returns to be more than a few cents, then you’ll need to allocate more capital to invest.
Upon learning that I needed sufficient capital to start investing, this led me to the question of “how do I accumulate the capital needed to become an investor?”
This question led me to learn the importance of saving, using credit responsibly, and the importance of not being an impulse buyer. I started learning more about financial literacy because becoming an investor indirectly required that I do so.
For me, I learned about financial literacy not because it was my original intent, but rather because I saw financial literacy as a prerequisite to becoming a skilled investor.
In the article “Is It Possible To Start Investing Too Early?”, I went over some reasons as to why an individual may want to put off investing for now, such as having an unstable financial situation or being prone to emotional thinking.
I believe that if a person seriously wants to become an investor, but isn’t in a position to become one right now, then they will address their financial weaknesses in order to make their dream of investing a reality.
So, my current level of financial literacy is a result of my original goal of becoming an investor. I learned about the importance of saving, using credit judiciously, and taxes because I needed to master these topics first if I wanted to have a decent shot at becoming a successful investor.
Is There an “Optimal” Approach?
Between the two scenarios we just looked at, with respect to developing your investing skills, is one approach better than the other?
I don’t see any major reasons why one approach could lead to better investment skills. A person who learned about investing by first trying to improve their financial literacy can be just as skilled an investor as someone who started learning about investing first.
Assuming a person is set on improving their investing knowledge and skills, then regardless of which scenario they find themselves in their level of investment skill and know-how should ultimately be the same.
The same can most likely be said about financial literacy. I started learning about investing first and developed my financial knowledge as a result of my investing study, and I can confidently say that my financial literacy is strong.
Just because you take one approach over the other doesn’t mean you’ll get a vastly different outcome. The scenarios I discussed above are simply the ones I’ve observed most people (including myself) experience whenever investing and financial literacy begin to intersect.
Wrapping Up
There’s no doubt that financial literacy and investing are related, but how exactly does that relationship work?
Does a desire to improve one’s financial health lead people to become investors, or do people develop their financial literacy because they know they want to become investors?
Most people usually end up in one of these two scenarios. However, regardless of which path an individual finds themselves on, the outcome should still be the same – strong financial literacy and investing skills as a result of consistent practice and study.
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