1. Introduction and Motivation
The literature has provided strong evidence that higher levels of financial knowledge are associated with more sustainable financial behaviors and higher levels of financial health [
1,
2,
3,
4,
5,
6]. As observed by van Raaij [
7], responsible financial behaviors improve personal financial well-being: individuals with responsible financial behavior are less likely to have financial problems, such as over-indebtedness, financial anxiety, and fragility, and to be exposed to investment fraud. Financial behaviors performed in a responsible and sustainable way entail taking controllable and calculated risks, retaining a sufficient part of income for unforeseen expenditures, preventing excessive debt accumulation, engaging in financial planning activities, avoiding impulsive decisions and purchases, and seeking financial advice when one’s own competencies are insufficient.
Financial knowledge significantly contributes to improving individuals’ economic performance, with beneficial effects on their well-being and, as a consequence, on the well-being of the society at large [
1]. In fact, people with lower levels of financial knowledge engage in high-cost transactions, incur higher fees and high-cost borrowing [
4], and are characterized by greater financial fragility and less ability to manage unexpected financial difficulties [
5]. Individuals who are more financially literate are more willing to seek professional financial advice or counselling than people who are less financially literate [
8] and are better able to detect financial fraud [
9]. Furthermore, they also have high awareness of the potential financial losses or gains derived from suboptimal financial decisions and thus are more willing to seek financial advice [
10]. As demonstrated by van Rooij et al. [
11], financial literacy could improve wealth accumulation and saving plans, being positively related to the likelihood of investing in the stock market. Long-term financial planning capabilities also affect retirement planning behavior, which is associated with better retirement security [
12,
13]. Lusardi and Tufano [
4] also emphasize the significant role of knowledge of the concepts related to debt (i.e., debt literacy) and financial experiences in reducing over-indebtedness.
A further aspect, still scarcely explored in the literature, is the link between financial knowledge and socially responsible investments. Financial literacy and environmental knowledge (i.e., eco-literacy) are generally considered factors that increase preferences for ethical financial companies, which in turn play a key role in promoting sustainable investments [
14]. As discussed in Phillips and Johnson [
15], a lack of knowledge of the social investment market and inadequate financial literacy represent significant barriers to participation in socially responsible investments. Gutsche and Zwergel [
16] point out that basic knowledge and trust in providers of socially responsible investment products are required to overcome at least some of the barriers that limit this kind of investment. Moreover, they find that eco-labelling schemes (especially sustainability certificates) contribute to decreasing information costs for individual investors, encouraging their participation in socially responsible investments. However, Gutsche et al. [
17] show that financially literate individuals in Japan, despite being more aware of sustainable investments and having lower participation costs, tend to shun sustainable financial products, possibly to avoid limited risk diversification and restricted investment opportunities related to sustainable investment strategies (e.g., negative screening). In this respect, Rossi et al. [
18] also show that individuals who perceive themselves as very knowledgeable in financial matters tend to allocate much lower amounts to socially responsible investments; conversely, individuals who have more objective financial knowledge are significantly more likely to participate in social investments.
Besides objective financial knowledge, self-assessed financial knowledge provides a measure of confidence in one’s own financial capabilities and is generally considered an important element for understanding individual financial behavior [
10,
19]. However, several authors have highlighted that individuals tend to misjudge their skills, incurring cognitive biases. Over- and underestimation of one’s actual performance, as well as over- and underplacement of one’s own performance relative to others, lead to overconfidence and underconfidence biases, respectively [
20]. Recent studies have focused on confidence biases in the self-assessment of financial competencies, showing that individuals tend to misjudge their financial skills. The misperception of one’s own financial competences and skills may entail negative consequences for financial behavior and decision-making, which affect individual financial well-being in the short- and medium-long term [
21]. Specifically, overconfident individuals present a higher likelihood of having carried out some retirement planning, but they do not demonstrate actual retirement preparedness [
22]. The condition of overconfidence is associated with various risky behaviors that can have detrimental effects on financial health [
23]. A higher self-perception of financial literacy results in a lower propensity to seek financial advice and leads to riskier financial behavior [
24,
25,
26]. Moreover, overconfident individuals are found to be more likely to experience losses due to investments, or to suffer fraud through unauthorized use of payment cards [
27]. Coherently, underconfidence bias leads to investment choices that are not value-maximizing [
28] and has a significant negative impact on wealth accumulation and on stock market participation [
11,
29]. Perceived financial knowledge is relevant for information-searching behavior with regard to socially responsible investments and affects the manner in which consumers make investment decisions [
15].
Previous literature has also pointed out the existence of significant gender gaps in financial knowledge and self-confidence. Both financial literacy and confidence matter for financial decision making and, as demonstrated by Bucher-Koenen et al. [
30], much of the gender gap in financial knowledge can be attributed to differences in confidence and the remainder to true knowledge differences. Accordingly, Aristei and Gallo [
31] provide international evidence that women are less likely than men to overestimate their financial skills but tend instead to underestimate their actual financial competencies.
Our work aims at contributing to the literature by providing new insights into the role of financial knowledge and confidence in shaping individual financial behaviors. Using microdata from the “Italian Literacy and Financial Competence Survey” (IACOFI) and addressing potential endogeneity issues, we assess the effects of objective financial knowledge and of confidence biases in the self-assessment of one’s own competencies on financial market participation and sustainable financial behaviors. More specifically, following previous literature, we focus on the individual propensity to invest in financial assets, to be exposed to investment fraud, and to engage in unsustainable debt behavior. Furthermore, we assess respondents’ preferences for socially and environmentally responsible companies as a proxy for individual attitudes towards sustainable investments.
Based on the above considerations, we posit our first two research hypotheses:
Hypothesis 1 (H1). Financial knowledge exerts a positive effect on financial market participation, contributes to limit hazardous and unsustainable financial behaviors, and increases preferences for socially and environmental responsible financial companies.
Hypothesis 2 (H2). Controlling for the actual level of financial knowledge, confidence biases affect individual financial behaviors and play a crucial role in sustainable debt behaviors.
We further explore the role of misperception of one’s own financial competencies on financial behaviors and test the following two additional hypotheses:
Hypothesis 3a (H3a). Overconfident individuals are characterized by higher financial market participation but tend to engage in riskier and less sustainable financial behaviors.
Hypothesis 3b (H3b). Underconfident individuals show suboptimal investment choices and more passive investment patterns but are less likely to make hazardous financial choices.
The remainder of the paper is organized as follows.
Section 2 describes the data and the main variables used for the analysis.
Section 3 illustrates the econometric methods, while the empirical results are presented and discussed in
Section 4. Finally,
Section 5 draws conclusions and discusses policy implications.
3. Methods
We first consider a baseline standard probit regression of the binary indicators of individual financial behaviors discussed in
Section 2.2 on the number of correct responses to financial knowledge questions (
Objective FK), controlling for a large set of other individual observable characteristics. Formally:
where
is an indicator function (equal to 1 if the expression in parentheses is true and 0 otherwise),
represents different financial behaviors (i.e.,
Financial investment,
Investment fraud,
Over-indebted,
ESR attitude),
is a vector of covariates,
is the corresponding parameter vector, and errors
are assumed to follow a standard normal distribution.
Previous literature [
43,
44,
46] has emphasized that an individual’s objective financial knowledge may be endogenously determined with respect to her/his financial behavior. Endogeneity of financial knowledge may be due to an omitted variable bias stemming from the existence of unobservable factors that simultaneously influence individual financial behaviors and financial knowledge [
26,
47]. At the same time, endogeneity may be due to a reverse causation channel, as financial knowledge may be affected by the experience gained from previous financial decisions and by individuals’ efforts to improve their own financial competencies to better manage their investments [
13,
48,
49]. Furthermore, test-based measures of financial knowledge may not allow to properly measure ‘‘true’’ financial knowledge, and this measurement error may give rise to an endogeneity issue, possibly leading to downwardly biased estimates of the impact of financial knowledge [
11,
12]. All these potential endogeneity concerns should be properly taken into account to allow for a causal interpretation of the effect of financial knowledge on financial behavior. Following Klapper et al. [
2] and Fornero and Monticone [
13], we extend the standard (exogenous) probit model in Equation (1) to account for the potential endogeneity of financial knowledge. To this aim, we consider a probit model with one endogenous continuous regressor, which can be formalized as the following two-equation recursive system:
where the second equation defines a reduced-form equation for
Objective FK (i.e., the number of correct answers to financial knowledge questions) as a linear function of the exogenous individual-level covariates in
and a set of additional instrumental variables
, assumed to directly affect an individual’s financial knowledge (i.e., relevant) but not to directly impact individual financial behaviors (i.e., exogenous). The error terms
and
in model (2) are assumed to follow a bivariate normal distribution with zero means, variances respectively equal to 1 and
, and arbitrary correlation
(i.e.,
). Endogeneity of financial knowledge arises from the error correlation: when
, then
and
are correlated and a standard probit of
on
and
will lead to inconsistent estimates of the
and
parameters.
Following Pikulina et al. [
28] and Xia et al. [
29], we further extend the baseline model to take into account the role of confidence in one’s own financial competencies. Specifically, controlling for objective financial knowledge and other individual observable characteristics, we aim to assess the impact of overconfidence and underconfidence biases on individual financial behaviors. In our empirical analysis, we thus extend model (1) and consider the following extended standard probit specification:
which includes the binary indicators
Overconfident and
Underconfident as additional regressors. Further, in this case, differently from previous studies [
28,
29], we explicitly allow
Objective FK to be endogenously determined with respect to financial behaviors and specify the following bivariate recursive system:
where cross-equation error correlation
allows us to directly assess the endogeneity of financial knowledge with respect to individual financial behaviors.
In the next Section, we present and discuss results obtained from maximum likelihood (ML) estimation of the standard and endogenous probit models for the four binary indicators of individual financial behavior and compute average marginal effects to properly gauge the magnitude of the effects of objective financial knowledge and confidence indicators, while controlling for individual-level socio-demographic characteristics.
5. Conclusions
This paper contributes to the existing literature by providing evidence about the role of financial knowledge and confidence in shaping individual financial market participation, sustainable debt behavior, and preferences for socially and environmentally responsible financial companies.
In line with previous empirical studies [
30,
34,
46], we find that objective financial knowledge exerts a positive and statistically significant effect on financial market participation. Furthermore, we point out that overconfident individuals tend to engage in excess trading, being more likely to invest in financial assets than similar individuals who correctly assess their competencies, whereas underconfident individuals inappropriately choose passive investment patterns and refrain from riskier investments. This evidence supports the findings of previous literature [
10,
28,
29] and suggests that the systematic misjudgment of one’s own financial abilities may lead to negative consequences on financial planning and wealth accumulation.
Focusing on risky investment behavior and analyzing, in particular, the role of financial knowledge and confidence on an individual’s vulnerability to investment fraud, our results demonstrate that objective financial knowledge has no significant effect on the probability of being a victim of financial fraud; nevertheless, individuals who are more likely to invest in financial assets are also more exposed to financial scams. Confidence biases in assessing one’s own financial competencies emerge as significant determinants of individual susceptibility to investment fraud. In particular, we find that overconfident individuals are more likely to have experienced fraud than those correctly assessing their capabilities; at the same time, individuals who understate their financial abilities are less likely to expose themselves to hazardous financial behaviors. This evidence clearly points out the detrimental role of financial knowledge overconfidence on financial decision-making, confirming the results of previous studies [
7,
27,
61]. The analysis of debt sustainability highlights that overconfidence and less financial knowledge significantly impair individuals’ ability to manage their finances correctly and lead to unsustainable levels of debt.
Finally, objective financial knowledge significantly contributes to increasing the likelihood of preferring environmentally and socially responsible financial companies, suggesting that inadequate financial knowledge represents a significant barrier to individuals’ participation in socially responsible investments. Coherently, those who underestimated their financial knowledge are less likely to prefer dealing with ethical financial companies, as their lower level of investment experience and their passive investment behavior may reduce their awareness of environmentally and socially responsible investments and their understanding of sustainable financial products, usually characterized by a more complex structure than conventional products.
Our main results provide significant insights into the crucial role played by financial knowledge and self-confidence in improving individual well-being and social and environmental wealth. Therefore, programs aimed at increasing the average level of financial knowledge and the awareness of one’s own financial competencies could significantly contribute to reduce riskier financial behaviors and build a culture of sustainability, both maintaining debt at sustainable levels and encouraging the choice of ethical financial companies and sustainable financial products. These policies could be pursued through the implementation of financial education programs starting from primary schools and through financial inclusion and information plans aimed at the most vulnerable and fragile groups in society (e.g., women, young people, persons with low income levels). Moreover, the reduction of information deficit and asymmetries, by means of targeted and transparent information documents and contracts, could improve understanding of the financial structure of socially and environmentally sustainable investments and the performance of this kind of investment. Since individual investors are prone to judgment and decision-making errors in their investment choices, the promotion of cost-controlled financial advisory activities could also ensure greater awareness of investment choices and a more sustainable debt burden in the medium–long term. Nevertheless, policy interventions supporting environmental values and the ecological political identification of a country could also play a significant role in incentivizing individual sustainable investment behavior.