Academic journal article Financial Services Review

Financial Literacy and Financial Behavior: Assessing Knowledge and Confidence

Academic journal article Financial Services Review

Financial Literacy and Financial Behavior: Assessing Knowledge and Confidence

Article excerpt

1. Introduction

Financial literacy is a measure of the degree to which one understands key financial concepts and possesses the ability and confidence 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 the 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 confidence (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 the number of correct answers to multiple-choice and true or false questions. Financial confidence 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 confidence influence financial behaviors, and surprisingly, the effect of financial confidence on behaviors is just as important as the effect of financial knowledge. Furthermore, confidence is an important predictor of financial behavior across all actual financial knowledge level groups.

Additionally, by examining the interaction of financial knowledge and confidence, this study expands on the literature related to overconfidence, or the tendency to overestimate one's accuracy and to underestimate risk. In instances where confidence 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 confidence influences financial behaviors: confidence 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 the 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 the pervasiveness of financial decisions in every individual's daily life.

The article is organized as follows. Section 2 provides an overview of the literature, touching on financial literacy, perceived knowledge, and overconfidence. Section 3 details the hypotheses, as well as an overview of the data, measures, and methods. Section 4 presents the results and Section 5 concludes.

2. Literature review

2.1. Financial literacy

Mandell (2008, p. 257) describes financial literacy as "the ability of consumers to make financial decisions in their own best short- and long-term interests." At its most basic level, "financial literacy relates to a person's competency for managing money" and "is typically measured at the individual level and then aggregated by groups" (Remund, 2010, p. 279). Because of the changing economic environment (e.g., see Organisation for Economic C-operation and Development [OECD], 2005), financial literacy initiatives have received much attention.

Research suggests that financial education has a positive effect on financial behaviors: education programs and seminars affect savings and total financial wealth (Lusardi, 2004), and individuals who studied economics or business in high school are less likely to be unbanked (Bernheim, Garrett, and Maki, 2001; Grimes, Rogers, and Smith, 2010). …

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