Impact of inflated perceptions of financial literacy on financial decision making

Abstract

We examine whether inflated perceptions of financial literacy affect financial decision making. Gaps between objective financial literacy and self-reported (perceived) financial literacy (blind spots) predict 19 financial behaviors better than age, gender, income, ethnicity, marital status, self-employment status, and general education levels. Only two predictors, perceived financial literacy and financial education, carried similar levels of predictive power on financial behaviors. Those with inflated perceptions of financial literacy are more likely to miss mortgage payments, receive a collection call, use informal debt, and have poor banking behavior. Those without blind spots make better financial decisions. The differences between those with and without blind spots are more pronounced among individuals with higher education and income.

Introduction

Financial literacy, the ability to understand financial matters and have the skill and willingness to act on that knowledge, leads to better financial decisions (Vieira, 2012), broader economic growth and increased individual financial well-being (Statman, 2017). Citizens in all regions of the world score low in financial literacy, making this an area of keen interest (Kell, 2014, Vieira, 2012). For instance, in a global survey of financial literacy, the United States is ranked 14th among 148 countries, with only 57% of Americans making a passing grade in a standard financial literacy test (Zumbrun, 2015). The 2008 global financial crisis highlighted the devastating impacts of poor consumer financial choices. In this study, we investigate whether inflated perceptions of financial literacy adversely affect financial decision making.

Lusardi and Mitchell (2014) propose a theory using rational framework where financial knowledge is an investment in human capital and its effect on financial decision making. A meta-analysis of 201 studies find that literally billions of dollars are spent to increase financial knowledge with very little impact on financial behaviors (Fernandes, Lynch, & Netemeyer, 2014). In other words, increasing objective financial knowledge alone does not seem effective in improving financial decision making; other psychological traits and cognitive biases that are not easily changed could have bigger influence in financial choices (Fernandes et al., 2014).

Studies that incorporate both perceived and objective financial literacy find that perceived financial literacy is more related to financial choices than objective financial literacy and that individuals tend to overestimate their financial knowledge (LaBorde et al., 2013, Vieira, 2012). Better financial behaviors could also stem from willingness to apply knowledge, not just acquiring objective knowledge (Kempson, Collard, & Moore, 2005). Choices can also be a function of biases or self-control that are not consistent with objective financial knowledge (Carlin and Robinson, 2012, De Mesa et al., 2008).

Past studies have examined the effects of objective and self-perceived financial literacy on financial decision making separately. We focus on the inflated perceptions or the difference between self-perceived and objective financial literacy on financial decision making. The illusion of knowing is a cognitive bias most commonly known as Dunning-Kruger effect (Kruger & Dunning, 1999). If a person does not know that (s)he does not know, will (s)he make worse decisions than someone who is aware of (her) his low ability and potentially seeks more information before making a financial choice? This study investigates whether thinking or perceiving that one has medium to high financial literacy when the objective financial literacy is low, increases the risk of financial pitfalls and high-risk financial behaviors.

The classic definition of overconfidence in behavioral finance is to hold a false assessment of one’s own skills and talent. Daniel and Hirshleifer (2015) conclude that overconfidence is an important building block for behavioral finance models and provides explanation for why investors who receive the same public information disagree so much, neglect important information, and trade more. Chuang and Lee (2006) provide empirical evidence for overconfident investor behaviors, such as, over-reacting to private information, aggressive trading and excess volatility, and underestimation of risks. Self-attribution bias (attributing success to confidence, but failures to bad luck) maintains such overconfidence and contributes to momentum (Gervais & Odean, 2001). However, these models include dynamic aspects, such as learning from past experience and changing financial behavior. Merkle (2017) finds overconfidence leads to over trading, less diversification, and higher risk-taking, along with evolution of overconfidence based on past success. However, the Dunning-Kruger effect’s focus is on overconfidence due to ignorance and the inability to realize about that ignorance (Dunning, 2011).

We measure inflated perceptions of financial literacy by the gaps between self-perceived financial capability and the objective financial literacy,1 which we call “blind spots”. We examine whether such inflated perceptions (e.g., overconfidence) are more problematic than just low financial knowledge, even after controlling for several socio-demographic factors, such as, age, education, employment, income, marital status, race, gender, and financial education (both formal and family-based) that are known to affect financial literacy based on past studies (Lusardi & Mitchell, 2014).

Using the 2015 Financial Industry Regulatory Authority (FINRA) Investor Education Foundation sponsored National Financial Capability Survey (NFCS) data, we examine whether the gap between perceived and objective financial literacy is associated with worse financial decision making in the areas of credit card use, household budgeting, risky financial behavior, savings for the future, and overall satisfaction with financial condition.

Our results indicate that the inflated perceptions of financial literacy is a significant determinant of sub-optimal financial outcomes, after controlling for several known socio-demographic factors affecting financial decision making. Further, the large gaps, or blinds spots, seem more concentrated among better educated men making over $75,000 a year. These men have the financial freedom to avoid weak financial choices such as informal debt, credit card fees, and overdrafts in their checking account, but do not seem to choose to do so. Our results reveal a new variable, an unknown area of weakness that also explains weak financial choices than prior literature.

Our paper is organized as follows. We review the relevant literature and develop our hypotheses in Section 2. We explain our data sources and measures used in Section 3. We present the results in Section 4. We conclude with the implications and contributions of our study in Section 5.

Section snippets

Literature review and hypotheses development
Not knowing about personal finance hampers a household’s ability to withstand short and long term financial vicissitudes and build financial safety nets (Allgood & Walstad, 2016). Consumers with low financial knowledge find it difficult to identify products and services appropriate for their situation and avoid abusive practices (Agnew and Szykman, 2005, Kempson et al., 2005). The costly mistakes have spurned growing interest among economists, professionals (Cakebread, 2014), and academics

Data source and measures
We use the NFCS survey data. The NFCS was commissioned by the FINRA-Investor Education Foundation and was conducted in consultation with the U.S. Treasury Department and the President’s Advisory Council on Financial Literacy to provide insight on the financial capability of the national population. The survey was conducted in 2009, 2012 and 2015. We use the 2015 data because this survey data is not influenced by the sub-prime financial crisis or the recovery after the financial crisis. The 20152

Perceived financial literacy
Perceived financial literacy was measured, using a Likert scale 1–7, 1 = very low, 7 = very high. We split this variable into three groups: low (4 or under), medium (5) and high (6 or 7), which is a bit more nuanced than Allgood and Walstad (2016), who split the literacy measure into those above mean and below mean. The perceived financial literacy scores similar to Allgood and Walstad (2016) obtained similar results.
Objective financial literacy
Objective financial literacy is measured by the sum of correct answers on five

Objective financial knowledge vs. perceived financial knowledge
The objective financial literacy, perceived financial literacy, and the percent with blind spots by income in Table 2 and by gender and ethnicity in Table 3.We find that 42.2% of respondents in the NFCS survey have well-calibrated financial knowledge, where the perceived and measured financial knowledge is similar. We find 20.7% are slightly over confident (actLow, perMed), and 12.8% are very over confident (actLow, perHi) about their knowledge. We find significant differences between objective

Conclusion and implications
We unearth a cognitive bias impacting consumer financial behavior. Instead of concentrating on the levels of financial knowledge or perceptions of financial knowledge, we study the gap between these two. That is, rather than “not knowing” as the explanatory variable, we substitute “illusion of knowing”, that we call a blind spot. The blind spot is a proxy for overconfidence and a cognitive bias known as Dunning-Kruger effect. We present empirical evidence that blind spots are highly correlated

Acknowledgements
For helpful comments, we are grateful to Francisco Lopez, James Thomson, two anonymous reviewers, and participants at the 2017 American Accounting Association Conference.

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