This article explores overconfidence as a critical behavioural bias in financial planning clients.

In order to be able to satisfy the best interests duty, financial planners need to have an accurate understanding of their clients, including their clients’ attitudes and financial literacy.

While we recognise the need to assess client’s financial literacy, the process of assessment is more complicated. There are several domains of financial literacy, and knowledge is only one aspect. How one behaves and their attitudes also impact on their financial capability (Atkinson and Messy, 2012; Oaten and Cheng, 2007). One such behavioural bias is overconfidence, particularly in one’s financial literacy.

Overconfidence is of particular concern for planners given there are a number of ways it can potentially negatively impact on financial decisions (Porto and Xiao, 2016). There is evidence of behavioural issues where overconfident investors trade more and earn inferior returns (Barber and Odean, 2001), and that overconfidence can lead investors to underestimate risks and shortcomings of certain investment options (McCannon, Asaad and Wilson, 2016).

However, one of the main concerns for planners is that overconfident clients may believe they possess more knowledge and understanding than they actually do.

Inaccurate understanding of finance and investing has been shown to drive investing behaviour (McCannon, Asaad and Wilson, 2015). Clients who are overconfident in their financial literacy may therefore pursue higher-level financial advice, which perhaps they are not fully capable of comprehending. This can create problems for the efficacy of a financial plan and could potentially lead to disputes.

Previous studies have found a discrepancy between survey respondents’ self-assessed financial literacy and actual financial literacy (Ali, Anderson, McRae and Ramsay, 2014; Lusardi and Mitchell, 2011; Van Rooij, Lusardi and Alessie, 2011), with a recent study suggesting perceived financial literacy has a similar influence on financial behaviour as actual financial literacy (Allgood and Walstad, 2016). In that case, a client’s self-assessed financial literacy could be a better indicator of how they will approach financial decision-making.

This study had two aims. First, it sought to identify the prevalence of overconfidence, and second, to identify if there are any demographic characteristics associated with overconfidence.

The authors used an online survey and respondents were asked to self-rate their understanding of the following eight topics: budgeting, saving, managing debt, investing, retirement planning, taxation, insurance, and superannuation.

The study found that overall, the sample was slightly under-confident in its financial literacy. Most people can accurately identify their ability in eight areas of financial literacy, however, there are some key differences. An examination of those who are categorised as overconfident in their financial literacy found respondents with English as a second language (ESL) were significantly more likely to be overconfident.

This finding may assist planners to identify those clients at most risk of this form of overconfidence, allowing them to take further steps to identify this bias and provide appropriate advice.

This study proposes that while assessing financial literacy of clients is important for financial planners, they must also give consideration to the self-perceived versus actual financial literacy.

Differences between perceived and actual financial literacy can manifest as overconfidence or underconfidence, and while both potentially have negative behavioural and knowledge-based consequences for financial capacity, this study has focused on overconfidence given the risks for financial planners in ensuring they satisfy their best interests duty.

These findings underscore the importance of planners using both self-rated and objectives measures when determining a client’s level of financial literacy.

Dr Laura de Zwaan, Dr Chrisann Lee and Dr Yulin Liu are from the Queensland University of Technology, and Dr Toni Chardo is from the University of Southern Queensland.

This report was published in the ‘Financial Planning Research Journal’ (Vol 3, Issue 2, 2017). To read the report in full, go to: www.fpa.com.au/education/financial-planning-research-journal/