Relationship between an inconsistent degree of financial literacy and inconsistent decision-making in intertemporal choices

Abstract

Intertemporal choice refers to the decision-making process involving trade-offs between rewards available at different points in time (such as choosing between smaller immediate rewards versus larger rewards later on). Empirical evidence often deviates from the exponential preferences predicted by the normative model. A hyperbolic discount function better mirrors individual behavior, explaining temporal inconsistency – whereby preferences vary over time by applying a higher discount in the present. Hyperbolic preferences are associated with addictive behaviors, such as smoking and alcohol consumption, as well as depression or attention deficit hyperactivity disorder. Established measures in the literature quantify the extent of deviation from exponential trend exhibited by hyperbolic preferences.In addition to behavioral and cognitive factors, it is essential to incorporate financial literacy into the examination of individual decision-making behaviors. The present study analyzes the relationship between the degree of decision-making inconsistency and the degree of financial literacy inconsistency across three dimensions: knowledge, behavior, and attitudes. It aims to illustrate while financial literacy is important, it is not sufficient to ensure rational choices. Rather, it reveals a strong correlation among its dimensions. The results of this research could be included when creating investor profiles required by MiFID, considering insights from behavioral finance studies in these profiles. What is more, understanding psychological biases that can influence financial decision-making empowers investors to make more informed decisions and avoid common pitfalls.

Keywords

• Intertemporal choice
• Hyperbolic discounting
• Inconsistency
• Financial literacy
• MiFID
• Investor profiling