A Methodological Issue in the Measurement of Financial Literacy

Abstract

INTRODUCTION In order for an individual to function in our increasingly complex modern society, one must develop a basic understanding of investing, insurance, credit and debt management, and other personal finance topics. Knowledge of these topics is often referred to as financial literacy. Unfortunately, the level of financial literacy in modern American society is generally viewed as being unacceptably low. In a press conference on January 22, 2008 President George W. Bush announced that he was responding to the problem with a special presidential advisory group. Earlier today I signed an executive order establishing the President's Advisory Council on Financial Literacy. I have asked people from the business world, the faith world, the non-profit world, to join this council in order to come up with recommendations as to how to better educate people from all walks of life about matters pertaining to their finances and their future. ... if we want America to be as hopeful a place as it can be, we want people owning assets. We want people investing. We want people owning homes. But oftentimes, to be able to do so requires literacy when it comes to financial matters. And sometimes people just simply don't know what they're looking at and reading. And it can lead to personal financial crisis, and that personal financial crisis, if accumulated to too many folks, hurts our country. Concern about the level of financial literacy has been developing for many years, and is a topic that has been actively explored by the academic community. Research into this topic has resulted in an extensive body of literature being developed to explain the general public's level of financial literacy. Many of these studies have focused on observed behavior of individuals or have focused on surveys that have allowed researchers to ascertain survey respondents' level of financial knowledge in one or more of the areas of personal finance. A discussion of this literature follows below. The results of most academic surveys on financial literacy show respondents answering about half of the survey questions correctly, indicating a relatively low level of knowledge on personal finance topics. But does only being right about half the time imply that the respondents are about half the time? Where many researchers have failed to correctly interpret their own results is that they have simply treated responses as being correct or incorrect. Understanding responses on a survey of factual knowledge is much more complex than that. This study adds to our understanding of financial literacy by examining a methodology issue in how researchers measure financial literacy. Previous studies have failed to allow for the difference between respondents knowing the correct answers to basic knowledge questions and correctly guessing the answers to those questions. Previous studies (see Chen and Volpe, 1998; Volpe, Chen and Liu, 2006; and Worthington, 2006, for example) have also frequently failed to allow respondents to admit not knowing the answer to financial questions posed to them, implicitly not recognizing the difference between one being aware he is lacking in knowledge and one incorrectly thinking that he knows certain information. These two methodological errors result in previous studies potentially overstating the level of financial literacy and providing an incomplete description of what is contained in wrong answers. By correcting for these errors our first contribution is to broaden the understanding of the level of financial literacy. Our second contribution is to demonstrate that the opportunities for the academic community to educate students and for financial planners to educate clients (and potential clients), are greater than some may have anticipated. THE FINANCIAL LITERACY LITERATURE A multitude of studies over the past couple of decades have tried to explain how different personal variables affect (or fail to affect) the financial literacy of individuals. …