How financial literacy and reflection can prepare you for challenging times

By Ozan Isler, Onurcan Yilmaz & Uwe Dulleck
Posted on May 05, 2021

As the COVID-19 pandemic continues to threaten lives and livelihoods around the globe, the benefits of financial resilience have become crystal clear. For example, saving for the future and insurance coverage can help us deal better with adverse life events. That’s why we’re more excited than ever about our TFI research project. Our goal is to develop behavioural interventions that can help people prepare financially for negative shocks.

While we have not yet conducted our experimental tests of behavioural interventions, we are happy to unveil some of our preliminary survey evidence on the cognitive underpinnings of financial literacy, and its relevance for personal financial management.

The pioneering work of Lusardi and Mitchell indicates a prevalence of low levels of financial literacy around the world, associating this lack of knowledge with personal financial mismanagement (Lusardi & Mitchell, 2007, 2014). Arguably, financial preparedness for adverse shocks depends on a good understanding of available financial tools that can help deal with such shocks, as well as an ability to reflect on the appropriate financial decisions. Our survey results confirm this view.

Two surveys on financial literacy

We conducted two large-scale online studies among UK residents (N1 = 2,441; N2 = 3,667) between December 2020 and February 2021. We calculated a Financial Literacy Score (FLS) for each individual à la Lusardi & Mitchell, as well as a Cognitive Reflection Score (CRS).

The FLS measures an individual’s performance on five test questions about interest, inflation, and risk needed for effective personal financial management. Our improved financial literacy test included questions on the understanding of compound interest, such as:

Suppose you had £200 in a savings account without bank fees and the interest rate was 10% per year. How much would you have in the account after 2 years?” (Correct answer:More than £240.”)

Our data on FLS formed the heart of our correlational evidence, which was consistent with the argument that financial literacy improves financial wellbeing (measured as self-reported annual household income after taxes). The CRS, on the other hand, included standard questions such as:

“A [baseball] bat and a ball cost £1.10 in total. The bat costs £1.00 more than the ball. How much does the ball cost?” (Correct answer: “5 pence.”)

If you initially thought that the answer was “10 pence”, your intuition was wrong. Having resisted your initial reaction, and reflecting further, you likely realized that the correct answer is “5 pence”. Your reflective thought process could have been something like: “If the ball were to cost 10 pence, then the bat would cost £1.10, so both items would cost £1.20 in total, not £1.10 as described in the question. The answer cannot be 10 pence.”

In this way, the CRS measures an individual’s tendency to resist their initial, intuitive responses – by relying more on cognitive reflection.

These data suggest another important cognitive link: reliance on cognitive reflection and avoidance of intuitive responses can safeguard financial wellbeing. In both studies, we found that FLS and CRS were significantly and positively associated with each other, as well as with people’s income.

This suggests that interventions promoting reflection can help increase financial wellbeing by improving personal financial management, by increasing – for example – one’s understanding of compound interests and minimizing errors. We will be testing this hypothesis soon, in artificial and real-world settings.

We also measured financial literacy overconfidence (FLO), defined as the difference between one’s expectation of one’s own FLS and one’s actual performance score. In other words, the larger the FLO, the more overconfident one is about one’s personal financial decisions.

There is growing evidence that FLO negatively affects financial wellbeing due to bad financial decisions (McCannon, Asaad, & Wilson, 2015; Pikulina, Renneboog, & Tobler, 2017) or avoidance of sound financial advice (Porto & Xiao, 2016). In line with the literature, both of our studies showed that FLO is negatively correlated with both FLS and CRS. This suggests that successful interventions for promoting cognitive reflection and financial literacy could result in not only better-calibrated self-perceptions (for example, about one’s own capabilities and knowledge of personal financial management) but also in less error-prone financial decision-making.

Implications

Individual financial literacy reflects a combination of societal factors that can be very difficult and costly to change – think of family background, years of schooling and income distribution. Nevertheless, there is still room for improvement through scalable interventions that minimize the cognitive biases and decision errors (Basu & Dulleck, 2020), for example by relying on analytic, reflective thinking (Isler, Yilmaz, & Doğruyol, 2020).

We are planning to develop and test simple interventions that will increase people’s reliance on cognitive reflection. As part of the second study mentioned above, we already compared the effectiveness of eight promising reflection manipulations and found that providing a brief debiasing training improves cognitive performance. This training included three short questions addressing frequent cognitive biases as well as feedback on their solutions (like we did for the CRS question above). This type of brief debiasing training, we discovered, succeeded in increasing our participants’ cognitive performance

In a separate and even shorter intervention, we simply asked participants to explain their reasoning in a few sentences. Justifying one’s decisions significantly decreased the number of random decision errors.

Next steps

We’re very excited about our upcoming experiments. We will be testing the effects of novel behavioural interventions on performance in online personal financial management tasks, including saving for retirement and for insurance against adverse life events.

These experiments will hopefully deliver simple but effective decision tools aimed at boosting personal financial management and welfare. It will then be straightforward to integrate these interventions into typical banking websites.

Let’s start by testing out our behavioural interventions. We expect to share our results later this year. Keep tuned and stay safe.

References

  • Basu, A. K., & Dulleck, U. (2020). Why do (some) consumers purchase complex financial products? An experimental study on investment in hybrid securities. Economic Analysis and Policy, 67, 203-220. doi:10.1016/j.eap.2020.07.005
  • Isler, O., Yilmaz, O., & Doğruyol, B. (2020). Activating reflective thinking with decision justification and debiasing training. Judgment and Decision Making, 15(6), 926-938.
  • Lusardi, A., & Mitchell, O. S. (2007). Financial Literacy and Retirement Preparedness: Evidence and Implications for Financial Education. Business economics, 42(1), 35-44. doi:10.2145/20070104
  • McCannon, B. C., Asaad, C. T., & Wilson, M. (2015). Financial competence, overconfidence, and trusting investments: Results from an experiment. Journal of Economics and Finance, 40(3), 590-606. doi:10.1007/s12197-015-9328-4
  • Pikulina, E., Renneboog, L., & Tobler, P. N. (2017). Overconfidence and investment: An experimental approach. Journal of Corporate Finance, 43, 175-192. doi:10.1016/j.jcorpfin.2017.01.002
  • Porto, N., & Xiao, J. J. (2016). Financial Literacy Overconfidence and Financial Advice Seeking. Journal of Financial Service Professionals, 70(4).