Financial Literacy and Financial Behavior: Assessing Knowledge and Confidence

Abstract

AbstractThis article explores how financial literacy, comprised of both actual financial knowledge and perceived financial confidence, affect financial decisions. Using national survey data from United States, results indicate that financial is a critical component of financial literacy and is important across all knowledge levels. However, overconfident individuals, or those with high (or self-assessed) knowledge but low actual knowledge, have a higher propensity to engage in risky (costly) financial behaviors. Together, results suggest that financial literacy initiatives should focus not only on factual knowledge, but on helping individuals achieve a healthy dose of confidence. © 2015 Academy of Financial Services. All rights reserved.Jel classification: D03; D14; D80Keywords: Financial literacy; Confidence; Overconfidence; Financial behaviors; Risk1. IntroductionFinancial literacy is a measure of degree to which one understands key financial concepts and possesses ability and to manage personal finances through appropriate short-term decision making and sound, long-range financial planning, while mindful of life events and changing economic conditions. (Remund, 2010, p. 284)Financial decision making is an essential component of day-to-day life, from minor decisions such as deciding whether or not to purchase a latte to major decisions such as taking on a home mortgage. Several definitions of financial literacy highlight that to make sound financial decisions, individuals must not only possess necessary knowledge, but must also have the ability and confidence to apply their knowledge. This article explores how financial literacy influences financial behaviors. By examining two components of financial literacy, financial knowledge, and financial (or perceived knowledge), this article demonstrates that both components are critically important to sound decision-making.Using survey data from FINRAs 2012 National Financial Capability Study (NFCS), financial knowledge is measured by number of correct answers to multiple-choice and true or false questions. Financial reflects a self-assessed level of financial knowledge, which may or may not coincide with measured financial knowledge. This article demonstrates that both knowledge and influence financial behaviors, and surprisingly, effect of financial on behaviors is just as important as effect of financial knowledge. Furthermore, is an important predictor of financial behavior across all actual financial knowledge level groups.Additionally, by examining interaction of financial knowledge and confidence, this study expands on literature related to overconfidence, or tendency to overestimate one's accuracy and to underestimate risk. In instances where exceeds actual knowledge (i.e., overconfidence), an individual has a greater likelihood of engaging in risky (costly) financial behaviors, such as taking out a title-loan. A key contribution, therefore, is a better understanding of how influences financial behaviors: is good, but not if it greatly exceeds actual knowledge. Prior research associating perceived knowledge with individual financial behaviors has failed to reconcile instances in which inaccurate self-assessments can be harmful. This article shows that, overall, positive illusions are good. However, this article also illuminates particular risky situations in which overconfidence is self-injurious. These findings are relevant across a multitude of disciplines and are pertinent to individuals, practitioners, and institutions alike. There are clear implications for financial literacy initiatives, initiatives that are of utmost importance given pervasiveness of financial decisions in every individual's daily life.The article is organized as follows. …

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