Democratizing finance: solution or source of the problem?
For those interested in the world of Economics and Finance, the term Democratization of Finance is well known.
Numerous Nobel Prize winners, especially Robert Shiller, Nobel Prize in Economics in 2013, support this movement to reform the sector and make it accessible to a greater number of people.
First, to know the implications of this term, we are going to start from the definition to know all the points that this term covers and how it applies to the current Spanish society.
The definition of “Democratization of Finance” refers to the ‘‘gradual process of removing control of the finance industry away from the select few big banks/financial institutions and distributing the power among the public’’. [1]
But how can this democratization be achieved and what implications does it have on society? To achieve this democratization, it is necessary to cover the following points according to Professor Shiller: [2]
1. Financial institutions should cover and involve more people in their activities.
2. By various means as a society, we must be able to manage the risks of investors.
3. Involve people in financial decisions and increase access to financial advice.
In today's highly digitalized society, the rise of fintech in Spain has allowed different investment products to be completely accessible to the retail investor, with very reasonable fees and allowing him to manage his assets in real-time from his mobile phone. Financial innovations are a huge step forward in the democratization of finance but if not supported by points 2 and 3, they can become a problem rather than a solution.
The purpose of this article is to highlight the need for basic financial education so that the retail investor can manage the risk of his investments with a solid strategy well defined for his particular objectives and his level of risk aversion.
The origin of the problem is based on the fact that an important percentage of the world's population is unaware of the significance of terms such as inflation or compound interest. Financial education is a pending subject in many countries in Europe and its role is essential in favoring entrepreneurship, innovation, minimizing social inequalities, and increasing the health and welfare of society.
Stories of people getting rich quick from trading stocks, options, or crypto money flood social networks, showcasing exuberant lifestyles, and offering specialized online programs to turn you into an investment shark. They encourage new investors to invest by taking unnecessary risks and to become slaves to their behavior.
As in the wolf of Wall Street, the character played by Matthew McConaughey states as the number one rule on Wall Street: ‘‘Nobody, even if you're Warren Buffet or Jimmy Buffet, nobody ever knows if a stock is going to go up, down, sideways or turn in fucking circles, much less the brokers’’.
It doesn't seem the most sensible way to gamble away a family's savings that in many cases has cost a great deal of effort to earn. The hypothesis of efficient markets, like many things in Finance, is a half-truth because it is undeniable that there is a behavioral component.
This behavioral component together with the difficulty of access to real-time information for the retail investor makes it impossible to predict the behavior of financial markets.
In the same way that when we are presented with a serious illness we listen largely to the voice of medical experts and do not turn to other alternative medicine techniques. The strategy proposed in this article is to follow the guidelines of experts and university professors in the field for what is known as an ‘‘Intelligent Investor’’.
Finance and economics professors ensure that efficient risk management is essential through a highly diversified investment portfolio with a long-term strategy based on the return objectives and risk aversion of the retail investor.
But this story is not so glamorous, how a well-defined strategy with regular contributions allows an individual to beat inflation and achieve the financial independence sought through minimizing specific risk with highly diversified products such as index funds and ETFs. [1] [2]
Therefore, I claim the need for financial education in our society, to start from the need to invest due to inflation, to choose a solid long term strategy that allows us to protect retail investors from their biggest rival, their behavior, to obtain a considerable average return. We do not want the retail investor to spend his spare time trading in the financial markets trying to beat the professionals in the sector in many cases without success and losing significant amounts of money in commissions due to the high number of transactions. We want retail investors to do their job and enjoy their spare time with family and friends.
Because democratization is not only giving the tools to enable the whole population to invest globally but also education so that they can choose their path and future.
Finally, it should be pointed out that this article is only a warning to raise the interest of current and future investors, which will be followed by more specific articles focused on behavioral finance and the relevance of risk management. Besides, a strategy of passive management investment portfolio will be presented to each of the retail investor profiles.
References
[1] «Bricksave,» 2017.
[2] R. J. Shiller, «Democratize Wall Street, for Social Good,» New York Times, 2012.
[3] «Investopedia», 2020.
[4] «Investopedia», 2018
Definitions:
1. Specific risk. Specific risk is the risk associated with a particular company, industry or sector.
2. Index funds. Type of mutual fund or ETF with a portfolio constructed to match or track the components of a financial market index.
3. ETFs. Exchange-traded fund is a type of security that involves a collection of securities that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies.