The Effect of Financial Literacy on Probability Distortion in Decisions Under Risk and Uncertainty

Abstract

Previous researchers have investigated decisions under risk and uncertainty in the pursuit of better understanding the psychological factors that influence how we formulate our decisions. Several theories for modeling decision-making behavior have developed as a result of this research, such as expected value theory and prospect theory. This study expands on the previous experiment conducted by Gonzalez and Wu (1999), which investigated distortions of probability relative to stated probabilities, by exploring the effect that financial literacy has on probability distortion. 53 subjects participated in this study, all current Princeton University undergraduate students. Subjects completed a five-question financial literacy assessment (Task 1) followed by a revealed probability distortion task (Task 2). It was hypothesized that there would be an inverse relationship between subjects’ financial literacy scores and their degree of probability distortion, given subjects with higher financial literacy scores having a stronger ability to understand the characteristics of probabilities and rational decision-making models (Rieger et al., 2015, p. 644). It was further hypothesized that this relationship would not exist for measures of diminishing marginal utility, the other determinant of risk. A correlation analysis of the results from Tasks 1 and 2 found a significant and positive relationship between financial literacy and risk-seeking behavior. We then estimated parameters of prospect theory that best fit each subject’s choices in Task 2. Analysis of the financial literacy scores and the estimated parameters of prospect theory suggest that this relationship is mediated by probability distortion, and not by diminishing marginal utility, as hypothesized. The results from this study offer novel insights into the effect that financial literacy has on decision-making under uncertainty and support the notion that initiatives to improve financial literacy can benefit decision-making.