Academic journal article The Journal of Consumer Affairs

Using the Right Yardstick: Assessing Financial Literacy Measures by Way of Financial Well-Being

Academic journal article The Journal of Consumer Affairs

Using the Right Yardstick: Assessing Financial Literacy Measures by Way of Financial Well-Being

Article excerpt

Despite the proliferation of academic studies examining financial literacy and financial outcomes, no consistent definition or empirically validated measures of financial literacy exist. While a handful of questions have become the standard measures of financial literacy in previous research, little work has been done examining whether responses to these questions accurately capture underlying financial capability, or whether they causally relate to subsequent financial well-being. Taking advantage of longitudinal data from the Health and Retirement Study we examine whether some of the questions previously used as measures of financial literacy are consistent measures of financial knowledge and effective predictors of future changes in wealth. We find that respondents frequently do not consistently answer questions across survey waves and that the context in which a question is asked affects the likelihood of correctly responding. Moreover, our regression analyses suggest that correctly answering these questions, consistently or not, has little significant relationship to changes in wealth over time, and is often related to a decrease in future wealth. Our findings should give pause to researchers using the financial literacy questions examined here, particularly from cross-sectional data.

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Household financial well-being is increasingly determined by the ability of the family members to make complex financial decisions. Following the broad move from defined benefit to defined contribution plans, financial well-being in retirement is now increasingly dependent on effective management of savings and portfolio allocation decisions across both career (accumulation) and retirement (draw down) phases of life. More broadly, the recent financial crisis highlighted the perils of a large number of individuals making poorly informed decisions about complex mortgage products. Consequently, people's ability to make effective decisions about the use and management of their income, financial products, and investment portfolios is drawing growing attention from educators, businesses, community organizations, and government agencies (Hilgert, Hogarth, and Beverly 2003; President's Advisory Council on Financial Capability 2012). Policymakers are concerned that a substantial proportion of consumers lack basic financial knowledge and money-managing capacities, which are indispensable for them to ensure and enhance the financial well-being of their families.

A number of recent studies have found low levels of "financial literacy" in the American population (Lusardi and Mitchell 2007; Lusardi, Mitchell, and Curto 2010: Lusardi 2008; Hilgert, Hogarth, and Beverly 2003). Despite the proliferation of research examining the relationship between "financial literacy" and financial well-being, no standardized definition of financial literacy exists, and current measures of financial literacy have not been empirically validated as causal predictors of subsequent financial well-being or financial behavior (Huston 2010; Hung, Parker, and Yoong 2009). Additionally, high scores on current metrics have not been shown to predict long-term financial well-being or resilience to financial shocks. However, recent efforts have been made to develop a financial knowledge scale by relating a core set of existing financial literacy questions to underlying financial knowledge using psychometric analysis (Knoll and Houts 2012).

The bulk of existing financial literacy questions relate to knowledge of investing or involve numerical calculations. While knowledge of optimal portfolio allocation, relative asset returns, and asset risk may be salient to the financial well-being of higher socio-economic status respondents who possess 401(k) and brokerage accounts, the majority of the population does not make these types of investment decisions. It is unclear if these questions relate to an individual's ability to successfully navigate their day-to-day personal finances once demographics and other characteristics are adequately controlled for (Warmath and Elwert 2012). …

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