Overconfidence May Lead to Poor Emergency Planning

By the end of the Great Recession of 2008-2009, the stock market lost approximately 50% of its value and the average duration of unemployment was 40 weeks. During the COVID pandemic of 2020, the unemployment rate quadrupled from 3.5% to 14.7%. Although these events were truly catastrophic by any measure, they highlighted the need to build financial resilience among the population. Most studies propose that individuals accumulate at least three months’ worth of funds in an emergency account to cover unexpected changes in income. That seems a reasonable goal unless individuals display overconfidence in their own ability to understand the issue.

How does the perception of the need to hold emergency cash relate to overconfidence in one’s degree of financial literacy? The answer is surprising. Using survey data of 5,423 households obtained from the 2016 Survey of Consumer Finances, the authors argue that overconfidence in one’s financial literacy leads to a significant underestimate of the need for emergency cash. The literature is brimming with evidence on the impact of overconfidence on market pricing of securities and on the performance of nondiverse portfolio management teams. Why would it be different for the clients of financial advisors? Dealing with overconfidence is key if advisors are to assist clients become better prepared for financial emergencies and build financial resilience.

What, Me Worry? Financial Knowledge Overconfidence
and the Perception of Emergency Fund Needs

• Sunwoo Tessa Leea and Sherman D. Hanna
• Journal of Financial Counseling and Planning
• A version of this paper can be found here
• Want to read our summaries of academic finance papers? Check out our Academic Research Insight category.

What are the research questions?

1. How does overconfidence in one’s financial knowledge affect the perception of the need for emergency funds?
2. What is the relationship between spending behavior and the perception of emergency fund needs?

What are the Academic Insights?

1. The authors define overconfidence in financial knowledge as the overestimation of one’s financial understanding compared to actual ability. Four categories are used to classify both objective and subjective financial knowledge: overconfident, underconfident, appropriately high, and appropriately low. The median subjective emergency fund ratio is 1.4, indicating that most respondents perceive their emergency funds to cover only 1.4 months of expenses. Only 28% of respondents perceive that they need at least three months of emergency funds. Overconfident respondents perceive a significantly lower emergency fund ratio compared to those with appropriately high financial knowledge. The overconfident group reported their emergency needs to be 21.4% lower than those with higher objective and subjective financial knowledge.
2. The cumulative distribution of the subjective emergency fund ratio, which is the ratio of respondents’ perceived emergency fund needs to their monthly expenditures, is presented in Figure 1. This graph is critical as it illustrates the distribution and skewness of respondents’ perceptions regarding the adequacy of their emergency funds. The distribution of the subjective emergency fund ratio is highly skewed to the right. Most respondents have low ratios, indicating that they perceive their emergency funds to cover only a small percentage of their expenses. The median subjective emergency fund ratio is 1.4. The median respondent believes their emergency funds to be sufficient for only 1.4 months of expenses. The 99th percentile of the ratio is 59.7. Only a few respondents perceive their emergency funds to be extremely high relative to their monthly expenses. There are also very large outliers producing a skewed distribution. The maximum ratio recorded is almost 6,400, indicating extreme outliers in the data. The skewed distribution and the low median ratio suggest that overconfidence in financial knowledge may contribute to this underestimation.

Why does it matter?

The data suggests that a sizable portion of the population may be economically vulnerable in the face of unexpected financial shocks, as their perceived emergency funds are insufficient to cover extended periods of expenses. The implications of overconfidence in financial knowledge are significant for financial advisors, financial education and policy. The data suggests that a substantial portion of the population may be economically vulnerable in the face of unexpected financial shocks, as their perceived emergency funds are insufficient to cover extended periods of expenses.

For financial advisors: A small percentage, only 28%, of respondents reported a need for emergency funds at the level experts recommend. The practices of survey participants do not align with the advice typically dispensed by the experts. Advisors should consider spending more time discussing the advantages of establishing and maintaining funding necessary to cover 3 months of spending.

For financial educators: The findings underscore the need for financial education programs that emphasize the importance of adequate emergency funds and focus on the reducing the gap between perceived and actual financial needs, particularly among overconfident individuals.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

We examined the association between financial knowledge overconfidence and the perception of emergency fund needs using the 2016 Survey of Consumer Finances (SCF) dataset. Only 28% of respondents reported a perceived amount of emergency funds needed that would cover at least three months of estimated spending. We conducted an OLS regression analysis on the log of the ratio of perceived emergency fund needs to household monthly expenditure. Overconfident respondents perceived a ratio 21.4% lower than those who had objective and subjective financial knowledge above median levels. Overconfident respondents might be underestimating emergency fund needs, suggesting the importance of not only increasing objective financial knowledge but also making consumers aware of the limitations of their financial knowledge.