Financial Knowledge, Overconfidence, and Financial Behaviors of Individuals

Financial knowledge has emerged as one of the important factors affecting one’s financial behaviors and decision makings. This dissertation consists of three essays, each with a focus on the effects of the discrepancy between objective financial knowledge and subjective self-assessment of financial knowledge, or financial knowledge overconfidence. Respondents were categorized as having overconfidence in financial knowledge when they had high subjective financial assessment but low objective scores. The first study focuses on early withdrawals from retirement accounts. Early distributions could pose risk on one’s financial stability during retirement by permanently reducing retirement wealth. The first study used 2018 National Financial Capability Study dataset and examined how (1) objective financial knowledge, (2) subjective financial knowledge, and (3) overconfidence in financial knowledge were related to one’s behavior of taking hardship withdrawals and plan loans by conducting logistic regression and Two-Stage Least Squares (2SLS) Instrumental variable (IV) analysis. The analyses found objective financial knowledge being negatively related to hardship withdrawals and plan loans, but subjective financial knowledge being positively related to hardship withdrawals. Respondents with financial knowledge overconfidence were more likely to take early withdrawals than those with other combinations of objective and subjective knowledge. The second study is about respondent perceptions of emergency fund needs. Using the 2016 Survey of Consumer Finances dataset, OLS regression analysis was conducted on the ratio of perceived emergency fund needs to estimated monthly spending. Quantile regressions and 2SLS IV regressions were conducted for robustness checks as well. Based on the OLS regression results, the perceived emergency fund ratio of respondents with financial knowledge overconfidence is 21.4% lower than respondents with appropriately high confidence (above median objective and subjective financial knowledge). Lastly, the third study examined retirement adequacy. Many U.S. households may not be adequately prepared for retirement, and one of the challenges they face is perceiving their retirement preparedness realistically. I examined factors related to appropriately evaluating retirement adequacy, by focusing on the relationship between two discrepancy indices: (1) between objective and subjective financial knowledge, and (2) between objective and subjective assessments of retirement adequacy. Using the 2016 Survey of Consumer Finances dataset, logistic, multinomial, and 2SLS IV regressions were conducted. About 72% categorized themselves as expecting to have enough retirement income, while I projected that 50% would have adequate retirement income. Projected and perceived adequacy aligned for 60% of respondents. Those who are overconfident in financial knowledge were less likely to have enough retirement income and more likely to be categorized as Unrealistic Optimists, who perceive themselves as having enough retirement income, while lack projected adequacy.The main implication of these three studies is that the respondents who are overconfident in financial knowledge might be making suboptimal financial decisions. The importance of financial education needs to be emphasized, and financial education should focus on not only increasing objective financial knowledge but also making people aware of the limitations of their financial literacy. The study also provides implications for policymakers and financial professionals regarding diverse financial behaviors to improve the financial well-being of individuals and households.