One considerable (and unfortunately common) challenge for financial planners is getting clients to focus on the goals they ought to focus on from a purely financial perspective, despite the psychological and behavioral biases which may direct their attention elsewhere. For instance, many households overemphasize accumulating assets (when they should be paying down debt), or overemphasize paying down debt (when they should be accumulating assets). To further complicate things, household preferences for accumulating assets versus paying down debt can sometimes shift in a seemingly confusing manner. However, an interesting new line of research points to one seemingly irrelevant factor which can be lurking in the background and influencing how clients perceive their wealth: whether their total net worth is positive or negative.
In this guest post, Dr. Derek Tharp – a Kitces.com Researcher, and a recent Ph.D. graduate from the financial planning program at Kansas State University – examines research on how our net worth may influence our perceptions of and preferences for holding assets and debt, and particularly the tendency to prefer having more assets when our net worth is negative, but less debt when our net worth is positive.
Mental accounting is a key concept of behavioral finance, which refers to the ways in which we mentally categorize assets, transactions, and other financial information in our heads. In theory, all of our resources should be fungible – dollars are dollars, regardless of what (liquid) account they’re in – but in practice, this is not how we typically behave. A study by Abigail Sussman and Eldar Shafir explores one particular form of mental accounting – the ways we tend to categorize assets and debt based on our net worth. By presenting participants with financial profiles that were equivalent in net worth but varying in the structure of their balance sheets, the researchers found that people tend to prefer having more assets when net worth is negative, but less debt when net worth is positive. For instance, despite the fact that net worth is actually the same -$100,000 in both scenarios, households tend to indicate a preference for having $100,000 in assets and $200,000 in debt over just $10,000 in assets and $110,000 in debt. However, if the assets and liabilities in the scenario above were reversed (i.e., net worth was positive $100,000 instead), then households would tend to prefer simply paying down their debt (even if it means having less in liquid assets)!
And this finding is notable, as it has several important implications from a financial planning perspective. For instance, it can help explain why people struggling with debt tend to accumulate assets and not pay down their debt, even if they’re keeping cash in a 0.25%-yield savings accounts while compounding 22% credit card interest rates. Additionally, this may be why affluent clients who can afford lots of leverage still often want to pay down their mortgage. Which, ironically, may mean that the people who can afford to “prudently” use leverage tend to eschew it, while those who can least afford leverage tend to engage in high-debt-profile behaviors that may actually amplify financial fragility! Further, preferences may seem to shift suddenly, particularly as households pay down student debt and begin to move into positive net worth territory, which may (or may not) align with what they should actually be focusing on. And for those who enter positive net worth territory quickly, there may be an overemphasis on paying down debt relative quickly (now that they “can”), rather than saving into investment accounts which may grow at a higher rate in the long-run.
Ultimately, the key point is to acknowledge that seemingly irrelevant factors (such as a household’s net worth) can influence how households perceive their financial situation, the decisions they make as a result, and their willingness to keep accumulating assets (while not paying down the debt) versus liquidating assets to reduce their debt profile as well. As a result, the way we as financial planners communicate with clients and frame these discussions can have a big impact on whether clients do (or do not) ultimately adopt our recommendations. Which means it’s important to understand the factors which may be lurking in the background and influencing client behavior, even if those factors should (in theory) be irrelevant to a client’s behavior!