The Role of Financial Literacy and Risk Preference in Shaping the Investment Decisions of Individual Investors

Abstract

Financial literacy, and risk preference, are among the major determining factors of individual investors’ capability of executing informed investments in a dynamically evolving financial field. It is important to learn, first of all, the interplay among these variables to promote a healthy financial behaviour and prevent a choice of investment through negligence. The purpose of this study is to explore the interest in financial literacy concerning investment decision-making, and the relationship between risk preferences and financial literacy is captured. Quantitative research design was used and data were collected from 150 individual investors who are actively involved in financial markets using a structured questionnaire survey. Structural Equation Modeling (SEM) and regression analysis are conducted to examine the effect and moderation of financial literacy on the extent of risk preference and the decisions on risk in investment. The results also show that financial literacy powerfully influences the decisions in investment (β = 0.42, p < 0.001), demonstrating that financial literacy helps one to diversify a portfolio, plan financially, and secure long term wealth. In addition, risk preference matters as to how investment choices are formed (β = 0.38, p < 0.001), risk tolerant entities tend to more prefer stocks and mutual funds while risk intolerant entities tend to favor bonds and fixed income based instruments. Furthermore, when risk preference is controlled for the relationship between risk preference and investment decisions (β = 0.25, p = 0.004) was moderated by financial literacy indicating that it is important in increasing strategic and informed risk taking behavior. This is important for investors, financial educators, and policymakers since it suggests the importance of the development of financial literacy programs and the implementation of the regulatory interventions that will enable the investment decision making and risk assessment.