FINRA Study Considers Relationship between Overconfidence and Financial Literacy
Commentary by Steven Lofchie
In a study funded by FINRA's Investor Education Foundation, researchers found that financial overconfidence (i.e., high confidence in an individual's financial knowledge relative to their actual financial literacy) may result in excessive financial risk-taking.
The researchers surveyed a large sample of adults between the ages of 58 and 101 to review "financial decision-making including tests of financial literacy and ratings of confidence in their financial knowledge." The researchers identified "relatively small adult age differences in financial literacy and financial risk tolerance, and no substantial age differences in confidence in financial knowledge." (Age explained only about 1 percent of the variance in financial risk tolerance whereas overconfidence explained about 6 percent of the variance in risk taking.)
The researchers concluded that "knowing someone’s age alone is not diagnostic of their financial risk tolerance." However, "assessing perceptions of confidence in financial knowledge in addition to actual financial literacy" should be further researched. The researchers suggested that "perceived overconfidence could be used to identify clients where an advisor might want to spend additional time covering portfolio/investment risk or updating risk profiles." Overconfidence may be an important factor for seniors insofar as many adults over 60 "are likely to be primarily decumulating wealth [and that] overconfidence could affect the strategic spend-down process and how remaining invested funds are managed."
Notably, "the adults that the researchers determined were overconfident reported that despite being more financial risk-tolerant, they were not at a greater risk of being victimized by fraud."
Commentary
The Dunning-Kruger Effect: "People tend to hold overly favorable views of their abilities in many social and intellectual domains. . . .[T]his overestimation occurs, in part, because people who are unskilled in these domains suffer a dual burden: Not only do these people reach erroneous conclusions and make unfortunate choices, but their incompetence robs them of the metacognitive ability to realize it." According to study, "Paradoxically, improving the skills of participants, and thus increasing their metacognitive competence, helped them recognize the limitations of their abilities."
While the focus of the FINRA study was on aging, the results indicated that the more significant issue was financial knowledge, across all age groups.