How Self-Efficacy Shapes Financial Outcomes
Many financial decisions are made in an uncertain environment. For example, people evaluate whether the expected benefits of saving for a rainy day may or may not outweigh the cost of reducing consumption today.
Borrowers struggling to repay loans compare the potential benefits of avoiding default, such as preserving a good credit score, to the costs of reducing spending today or getting a second job to avoid defaulting on their debt. Many middle-aged people evaluate whether insuring their long-term care is worthwhile at the expense of the insurance premiums each month.
In all these choices, people consider a trade-off involving an action that is costly today and has an uncertain effect on how future outcomes might look. Therefore, people's subjective perception of this trade-off is likely to influence their decisions.
Self-Efficacy and Financial Behavior
Building on this idea, in my research with Prof. Brian Melzer from Dartmouth College, we examine the effect of subjective beliefs on financial behavior.1 People vary in their self-efficacy or the strength of their belief that their actions or efforts can influence the future. A very similar concept to self-efficacy is locus of control.
People with high self-efficacy are those we’d refer to as having an internal locus of control. They believe they can impact what the future will bring through their actions. People with low self-efficacy, or an external locus of control, believe that no matter what they do, the future will unfold in ways driven by other external forces.
A growing economics literature on noncognitive skills shows that self-efficacy is important for educational attainment and labor market success. In our work we investigate whether self-efficacy also matters for financial choices, such as defaulting on debt, setting aside emergency savings and insuring against risks.
Why might self-efficacy matter for financial decisions? Self-efficacy influences an individual's perception of the benefits from acting. Consider a borrower at risk of default. His efforts to avoid default are immediately costly and may be ineffective. If he has low self-efficacy, he will perceive his sacrifices to have little effect on his financial future and defaulting will appear optimal.
Why would he spend any effort today to try to avoid the bad outcome, if he believes that his actions have no impact on the bad outcome occurring, anyway? By contrast, a person with high self-efficacy will believe his actions can reduce his chance of default and thus may choose to sacrifice consumption or work longer hours today.
A simple way to conceptualize the role of self-efficacy is as an effort choice problem, where providing effort is costly but increases the chance of avoiding a poor outcome in the future. People with lower self-efficacy foresee less benefit from exerting effort or making sacrifices today, so they choose to spend less effort, which in turn increases the likelihood of a bad outcome.
Given this framework, we would expect individuals with lower self-efficacy to have higher rates of financial distress, spend less effort preparing for potential adverse shocks, and become delinquent at higher rates upon encountering such shocks.
Drawing on these insights, we use data from the National Longitudinal Survey of Youth (NLSY) to test whether self-efficacy affects financial choices and outcomes. Our main analysis uses the NLSY Child and Youth panel, which follows survey participants from early childhood through adulthood. The survey tracks individuals' cognitive and noncognitive abilities, including their self-efficacy, from an early age.
Once participants move into adulthood, they also report their labor and financial market experiences. The survey's financial variables include measures of borrowing, delinquency on loans and bills, bankruptcy and asset repossession, precautionary saving, and health insurance take-up. The sample includes adults ages 21 to 41. We extend the analysis by using the NLSY 1979 panel (the parents of those in the Child and Youth panel) to study additional financial choices — credit applications and denials, retirement preparations, and purchases of long-term care insurance — among older adults, ages 47 to 56.
How Self-Efficacy Influences Financial Distress
We document a strong negative correlation between self-efficacy and financial distress. Individuals with high self-efficacy, measured earlier in life, are subsequently less likely to default on outstanding loans or fall behind on bill payments than their peers with low self-efficacy.
In turn, they are also less likely to experience foreclosure, asset repossession or personal bankruptcy. Individuals with more self-efficacy also display greater use of traditional credit products such as credit cards, automobile loans, and mortgages and are less likely to be rejected for credit and turn to high-cost payday loans.
We use the detailed data of the NLSY to explore why self-efficacy displays a negative correlation with financial distress. We first rule out potential differences — in cognitive ability, risk preferences, education, earnings, net worth and parental support — that may confound the effects of self-efficacy.
We find that self-efficacy remains negatively correlated with financial distress after accounting for measures of cognitive ability, risk tolerance and time preference. As documented in prior studies, both education and earnings rise with self-efficacy. Nevertheless, self-efficacy remains strongly negatively correlated with distress after controlling for educational attainment and income.
We also examine sibling groups for whom the NLSY collects data on each individual to test whether parental support accounts for differences in self-efficacy and delinquency. Maybe people with high self-efficacy scores happen to come from families with great parental involvement, including financial assistance, and this is why we see them avoid financial distress.
We find that even when looking at siblings, who likely benefit from similar support from parents, we continue to find a strong negative correlation between self-efficacy and financial distress: namely, the sibling who early in life scored better in terms of self-efficacy will have a lower likelihood of financial distress later in life.
This implies that shared family support does not confound self-efficacy in our results. We also show that all our findings for self-efficacy hold even after we control for further differences in noncognitive ability, as measured by the "Big-Five'' personality traits — extraversion, agreeableness, openness, conscientiousness and neuroticism.
Finally, we show that lower self-efficacy individuals are not defaulting more because they are more indebted. As noted earlier, these individuals are, in fact, less likely to borrow through traditional credit market products.
Consistent with our hypothesis that higher self-efficacy leads to better future outcomes by increasing preparatory behaviors early on, we find that individuals with high self-efficacy are more likely to take precautionary actions to avoid financial distress. They are more likely to set aside emergency savings, purchase insurance and plan for retirement. Individuals with high self-efficacy are also more likely to obtain insurance coverage and plan for retirement.
Among younger adults, the purchase of health insurance increases with self-efficacy, even after controlling for income and the availability of employer-sponsored coverage. Among older adults, purchases of long-term care insurance and preparation for retirement (e.g., visiting with a financial planner) increase with self-efficacy, even after controlling for income and net worth.
Individuals with high self-efficacy are not only more financially prepared but also more resilient when facing income and health shocks. Individuals with low self-efficacy who experience a job loss or health problem default on their debt and bill payments at very high rates — more than 50% higher than the rate of those who remain employed and healthy.
By contrast, individuals with the highest self-efficacy experience little to no increase in default after an income or health shock. These findings are consistent with the notion that self-efficacy, through its impact on financial preparedness, promotes financial stability. The precautionary actions that self-efficacy engenders appear to matter the most for individuals from poorer backgrounds.
When we link young adults to their parents, we find that the negative correlation between self-efficacy and default is strongest for individuals who grew up in the least wealthy families. Specifically, the beneficial effect of self-efficacy on default triples when moving from the top tertile to the bottom tertile of parental net worth.
The Importance of Self-Efficacy for Financial Stability
Our results suggest that this specific non-cognitive skill, self-efficacy, or believing that one’s actions can actually shape one’s future, is particularly important for people from lower-income groups. They are less able to rely on other forms of support or insurance when difficult times occur, such as leaning on family financial support.
Our results have implications for understanding household financial fragility. According to Federal Reserve Board data from 2023, about 46% of U.S. adults are ill-prepared for financial disruption and would struggle to cover emergency expenses should they arise.2 It is, therefore, important to understand why some households become financially delinquent but many others do not.
Previously, economists thought about default as a strategic decision in which people trade off the benefits of expunging remaining debt payments against the costs of credit market exclusion, forgone collateral and social stigma. Our insight is that this view excludes an important factor that influences default. Our work shows that individuals' subjective beliefs — self-efficacy, specifically — affect how they perceive the costs and benefits of default.
We find that self-efficacy is a meaningful predictor of financial distress, alongside other factors such as income and spending shocks, strategic motivations, the structure of bankruptcy law, and cultural norms.
Going forward, more research is needed on how we can cultivate self-efficacy in people of all ages, starting early. Consumers and investors today may do well to reconsider when they believe their actions can’t change their financial futures for the better. Believing that what we do changes what we will experience later is, as it turns out, a valuable skill that helps us in many dimensions of our lives.
1Camelia M. Kuhnen and Brian T. Melzer, “Non-Cognitive Abilities and Financial Delinquency: The Role of Self-Efficacy in Avoiding Financial Distress,” Journal of Finance 73 (6): 2837-2869, December 2018.
2Jeff Horwich, “Amid a Resilient Economy, Many Americans Aren’t Ready for a ‘Rainy Day,’” Federal Reserve Bank of Minneapolis, May 31, 2024.
The opinions expressed are not necessarily those of Avantis® Investors. This information is for educational purposes only and is not intended as investment advice.
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