The unending pain of student debt: effect of risk preferences – Debarshi Nandy, Birzhan Batkeyev, Karthik Krishnan

Debarshi Nandy, Visiting Associate Professor, MIT Sloan School of Management

From The Finance Lab

The dangerous and sometimes disastrous consequences of student loan debt are well known. We know for a fact that students with high debt levels are less likely to be entrepreneurs, less likely to own a home when they are 45, and less likely to find an ideal job.  The value of a college education is therefore reduced dramatically for those who need to service the debt to pay for it.

However, until recently, few have studied the long-term effects of student debt on the net worth of families burdened by the loans.  With my colleagues, Birzhan Batkeyev and Karthik Krishnan, I recently set out to address this gap—showing once again that the very loans that are supposed to help students get a leg up on their financial future, hamper them in myriad ways instead.

Our groundbreaking analyses show that student loans have a causal effect on personal investment portfolio composition and that, in turn, impacts household net worth dramatically.  Our analysis shows that individuals who carry student loan debt are much more likely to keep their investments in lower paying and lower risk alternatives than they are to invest heavily in higher return investments such as stocks or mutual funds (risky assets). The basic distribution of this can be seen in Fig. 1 below, which shows that the average holdings drops by 37% with student loans.

Figure 1: Percentage holding of Risky Assets by College Education & Student Loans

Though stocks and mutual funds provide better return in the longer term, they are also riskier in the short term. The very heavy consequences of missing a student loan debt payment or defaulting on a loan means that families burdened with student debt are often reluctant to risk the budget padding that cash on hand allows them in order to invest in high risk investments. As a result, when they are young, student debtors are not making the investments necessary to amass a nest egg, instead preferring to keep their money in less risky investments—such as bank savings accounts. This tendency can have dramatic effects on a family for generations.

For example, our research shows that student debt leads to suboptimal investments in personal financial assets. The lower investment in high-earning assets leads to missed opportunities and the lack of ability to increase one’s wealth through prudent investments.

Given the recent strong performance of the stock market, this has had disastrous consequences on the net worth of families that carry student loans—consequences that will likely have generational effects—creating a vicious cycle where one generation’s student loans keep another generation in debt as they have to borrow to similarly educate themselves.

Read the full post at The Finance Lab.

Debarshi Nandy is a Visiting Associate Professor at the MIT Sloan School of Management.

Birzhan Batkeyev is an Assistant Professor at the Kazakh-British Technical University.

Karthik Krishnan an Associate Professor of Finance at the D’Amore-McKim School of Business at Northeastern University.

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