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Abstract

This article explores how financial literacy, comprised of both actual financial knowledge and perceived financial confidence, affect financial decisions. Using national survey data from the United States, results indicate that financial confidence is a critical component of financial literacy and is important across all knowledge levels. However, overconfident individuals, or those with high confidence (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; D80

Keywords: Financial literacy; Confidence; Overconfidence; Financial behaviors; Risk

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,...

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