Impact of Financial Literacy on the Behavioral Biases of Individual Stock Investors: Evidence from Borsa Istanbul

Abstract

1. IntroductionFinancial literacy has been attracting attention at an increasing rate due to factors such as increasing complexity and variety of financial products and services, sophisticated financial that households have to deal with, shifted responsibility for financial security in retirement from government onto and changing economic and demographic factors. This is in line with the findings of a research study conducted by the International Network on Financial Education (INFE) of OECD. The study finds that financial ignorance was one of the factors that exacerbated the impact of the 2007-2009 global financial crisis.Financial literacy is now globally recognized as an important element of economic and financial stability and development (INFE, 2009). Reflecting this importance, many institutions (e.g. Jump$tart Coalition for Personal Financial Literacy, National Endowment for Financial Education, Global Financial Literacy Excellence Centre) works on financial literacy at a national or global scale. Much of this work aims to improve individuals' knowledge, with the assumption that increase in knowledge will lead to changes in financial behavior and practice. The validity of this assumption is an issue of interest to the field of behavioral finance, which aims to shed light on financial behavior by drawing on the disciplines of economics and psychology (Hilgert, Hogarth, and Beverly, 2003: 309).Statman (1995: 14) defines mainstream finance as a body of knowledge that is built on a number of fundamental principles such as the Miller-Modigliani arbitrage principle, Markowitz's portfolio theory, Linter and Sharpe's capital asset pricing theory and Black-Scholes-Merton option pricing theory. Mainstream finance has shown growth in years based on two fundamental assumptions: Individuals make rational decisions and individuals are without prejudice in forecasting the future. (Nofsinger, 2004: 1). However, behavioral finance, a sub-branch of finance, is based on the assumption that are not fully rational. Thus, behavioral finance is a field that has emerged as an attempt to understand how emotions and cognitive errors affect the decision-making processes of investors (Suer, 2007: 97). Studies conducted in this field has shown that when making financial decisions, may behave irrationally and be under the influence of certain behavioral biases, defined as systematic judgment errors (Kahneman & Riepe, 1998: 53).In summary, financial literacy is a key point to be considered when the competence to make well-informed financial comes into question. However, it is not the only significant determinant of sound financial decision making. Behavioral biases, which affect investor behavior, also play a critical role in this process. People can suffer from behavioral biases and behave irrationally and as a result, can make investment mistakes. On the one hand financial literacy leads to better financial decisions; on the other hand, behavioral biases cause irrational financial behavior.Although financial literacy is an increasingly important topic in the world as well as in Turkey, academic work based on Turkish data is not abundant. In particular, studies that assess the level of financial literacy and examine its relationship with behavioral biases are scarce. We thus aim to investigate the association between financial literacy and behavioral biases, which may trigger irrationality during the financial decision-making process. This paper contributes to the literature concerning financial literacy level of stock investors and the impact of financial literacy level on the level of behavioral biases.The main research question addressed in this paper is: Is there a relationship between a decision maker's financial literacy level and the level of behavioral bias? In order to answer this question, the relationship between the level of financial literacy and the level of behavioral biases of individual stock investors, whose financial have a material impact not only on their own financial well-being but also on the overall economy, was examined. …