The Association between Financial Literacy and Trust in Financial Markets among Novice Nonprofessional Investors

INTRODUCTION A growing number of individuals are required to make their own investment decisions as private enterprise shifts from offering employees defined-benefit retirement plans in favor of providing defined-contribution retirement plans (Franklin, 2011). This shift requires individuals to take a more direct role in making long-term investment decisions, forcing many individuals to assume a new and unfamiliar role as a novice nonprofessional investor (Campbell, Jackson, Madrian & Tufano, 2011; Dorfman, 2013). Given that all investment decisions require an act of faith (i.e., trust) on the part of the investor, research that examines the effects of trust on investors' financial decisions is important to academia, policy makers, and financial market practitioners (Guiso, Sapienza & Zingales, 2008). Accordingly, the specific purpose of this study is to apply a theoretical basis to explain how novice nonprofessional investors' financial literacy (an antecedent of trust) affects their trust in the financial markets and in the individuals who operate the financial markets. This study defines financial literacy as the knowledge one has of concepts inherent to investing and to the operation of financial markets in general (Mandell, 2006). (1) Recognizing the literature is replete with various definitions of trust, this study follows the definition provided by Sapienza and Zingales (2012): "the expectation that another person or institution will perform actions that are beneficial, or at least not detrimental, to us regardless of our capacity to monitor those actions." Accordingly, an individual's decision to commit funds to a market-traded security requires that the individual trust the financial markets and the individuals involved in operating financial markets to function as intended (Changwony, Campbell & Tabner, 2014). While a robust stream of literature demonstrates that trust affects investors' participation in financial markets (Van Rooij, Lusardi & Alessie, 2011; Mayer, 2008; Guiso et al. 2008; Guiso, 2010; Georgarakos & Pasini, 2011), a paucity of research examines variables that affect trust itself. Given that many individuals are increasingly required to make their own investment decisions, an examination of variables that affect novice nonprofessional investors' trust is needed to establish a greater understanding of how trust can be fostered. Policy makers, in particular, should be especially interested in research that examines variables affecting novice nonprofessional investors' trust because: (1) novice nonprofessional investors' financial market participation rates are low, (2) their participation has declined significantly since the financial crisis, and (3) those novice nonprofessional investors who choose participate in financial markets remain chronically underinvested (Guiso, Haliassos & Jappelli, 2002; Changwony et al. 2014). By more thoroughly understanding the factors affecting trust, policy makers can pursue empirically sound policies to improve novice nonprofessional investors' trust, ultimately encouraging greater participation in financial markets. (2) Psychological contract theory concerns the mutual expectations regarding inputs and outputs owed to individuals which arise from the relationship existing between an individual and another party (Rousseau, 1989; Morrison & Robinson, 1997). Extending psychological contract theory from a labor market setting to a financial market setting, we predict novice nonprofessional investors' financial literacy will have a negative association with novice nonprofessional investors' trust in financial markets and the individuals who operate them. Research that applies psychological contract theory in labor market contexts demonstrates that as an employee become increasingly mature, that is, as an employee gains greater knowledge, the employee requires more of his expectations to be written into a formal labor contract (Shruthi & Hermanth, 2012). …