The average person in the UK has over £65,000 in debt (including mortgages), so one might assume that there is a level of comfort with debt. A recent study from Stanford suggests that might not actually be the case, however, and this can have significant implications for people with such a debt aversion.
The researchers explored whether individuals already burdened with debt tend to prioritize debt repayment over building savings. The researchers presented a risk-free investment decision in a study involving 638 US participants. Each participant received $5 to “invest” across virtual accounts with varying interest rates, resulting in significant returns over a week, potentially doubling their initial investment.
The accounts had positive balances, representing savings, or negative balances, symbolizing debt. Participants had to decide how to distribute the $5 across these accounts. One group had all savings accounts, while the other had a mix of savings and debt accounts.
An optimal strategy
To maximize returns, the optimal strategy was to invest the entire $5 in the account with the highest interest rate (always a savings account), disregarding balances and any debt. However, a third of participants focused on repaying debt, missing out on higher savings returns.
Although 25% correctly identified the account with the highest return, they only maximized returns after settling their outstanding debt. When explaining their strategy, participants wanted to eliminate all debt before prioritizing returns.
In the second phase of the study, the researchers delved into how individuals accumulate debt in the first place. Participants were again presented with four potential investments, all free of risks. The pivotal decision was whether they were willing to borrow from a low-interest account to capitalize on more lucrative investments – essentially, considering borrowing at a 5 percent interest rate to yield a 20 percent return.
The critical distinction here was that in the control group, the account from which participants borrowed already had some funds, preventing the borrowing from causing debt. Conversely, in the debt group, the borrowing account had no money, resulting in any withdrawals leading to debt. Despite this seemingly subtle difference, it significantly influenced borrowing behavior.
Debt concerns
When withdrawals led to indebtedness, participants were only half as likely to borrow for investment. In the control group, nearly 70 percent of participants borrowed the maximum amount, utilizing the extra funds to secure the highest possible return.
In contrast, less than 30 percent of participants did the same in the debt group. Once again, the study underscored a widespread reluctance to borrow, causing individuals to miss out on profitable investments.
The takeaway from this study is that merely having access to credit may not be sufficient to stimulate the adoption of sound investments, particularly for those averse to accumulating debt. Exploring alternative funding sources, such as grants, could potentially be more effective. Moreover, implementing debt forgiveness programs or income-based repayment schemes could enable individuals to manage their debt while simultaneously engaging in high-return investments.
