The Effect of Financial Literacy Confidence on Financial Risk Preference Confidence. A Lab Experiment Approach

Abstract

The study experimentally investigated the impact of financial literacy confidence (FLC) on financial risk preference confidence (FRPC) constructed from objective and subjective measures of financial literacy and risk preferences. Seven hundred seventy-two responses from 193 subjects were analyzed using the Random Effect Panel Regression (REPR) technique. The study reveals that FLC significantly impacts FRPC differently for overconfident and underconfident individuals. Specifically, the results show that an increase in FLC increases FRPC for overconfident individuals but decreases FRPC for underconfident individuals. Hierarchical Random Effect Panel regressions confirm that financial literacy residuals significantly impact risk preference residuals. The findings entail that cognitive abilities errors on subjective and objective measures of financial literacy correlate with risk preference errors on subjective and objective risk preference measures. Interestingly, the results show that increased financial literacy residuals lead to reduced risk preference residuals for individuals with high financial literacy. The results suggest that individuals with higher financial literacy can better align their subjective and objective measures of risk preferences. The study findings help to explain how FLC shapes the financial behavior of individuals making risky financial choices. The policy implications of these findings are that investing in financial literacy programs can assist individuals in making well-informed investment or saving decisions and can better manage financial risks. JEL Classification: D14, C19, D81, I22.