Why Financial Advice Cannot Substitute for Financial Literacy?

Abstract

This paper examines the ability of financial advice provided by sellers of financial services to substitute for financial literacy of customers. I set up a simple theoretical model in which an informed financial advisor communicates with a less informed customer of financial services. Given the existence of a conflict of interest from the advisor's perspective, the model predicts that only well financially sophisticated customers receive relevant information from the advisor. This fact tends to prevent less financially sophisticated customers from asking advice although they are the most in need of financial guidance. Overall, the model predicts a monotonic relationship between financial literacy and the demand for financial advice. I then use a representative sample of French households (PATER 2011) to test the predictions of the model. I find that financial literacy is strongly associated to the probability to ask a financial advisor. Decomposing the measure of financial literacy, I show that the relationship is weakly monotonic which provides support to the fact that financial advice cannot substitute for financial literacy. This result is robust to alternative specifications and instrumental variables regressions.