In 2002, Jack Whittaker won the Powerball lottery and received a gargantuan cash windfall — $314 million, the largest undivided prize in history at the time.
It didn’t last.
Due to excessive spending, gambling, irresponsible investing, and an inability to set boundaries, Jack burned through his money in five fleeting years.
But Jack isn’t alone. In fact, a staggering 70% of lottery winners end up broke within three to five years, according to the National Endowment for Financial Education.
It’s not just lottery winners either. Fox Business reports 78% of professional athletes go bankrupt after just three years of retirement. For example, Allen Iverson famously blew through $200 million of career earnings within just two years of retiring from the NBA.
Obviously, a plethora of reasons factor into this reality for lottery winners, athletes, and everyday people who experience sudden changes in income or socioeconomic status. Earnings volatility puts people in extremely difficult situations, especially if they don’t already have adequate financial education and ingrained money management habits.
Even so, how is it that the vast majority of people in these situations can’t retain even a modest fraction of their wealth? Why are Jack Whittaker’s and Allen Iverson’s stories repeated time and time again?
Emotions and Money
One reason is that emotions and money usually don’t mix well. Without education, discipline, and practice, our decisions naturally tend to lean on emotions for guidance. According to Michael Levine from Psychology Today, “Emotions drive 80 percent of the choices Americans make, while practicality and objectivity only represent about 20 percent of decision-making.”
So, this isn’t a stab at lottery winners or athletes. The fact is, as humans, we are heavily subject to our emotions by default.
The current economic circumstances aren’t helping reinforce logic either. Coming out of the longest bull market in United States history, segueing to a worldwide pandemic, and now into a highly volatile, inflationary bear market — we are in an environment that lends itself to emotional reactions and decision-making.
This image from the financial planning firm Ablestoke aptly illustrates the emotional rollercoaster of market cycles.
When our investments grow, we experience optimism and euphoria, evoking a sense of self-attribution and an eagerness to continue investing. As the market nears its peak, many investors also begin to invest beyond their means, or without proper due diligence, as greed and fear of missing out come into play.
Alas, what goes up…must come down.
The inverse happens when our investments retreat. We start to question our strategies and expectations, which turns to panic and denial. The fear of further and/or total loss leads to selling when prices are low — a disastrous move for portfolios and a prime example of loss aversion. The pain of losing is twice as potent psychologically as the pleasure of gaining. Therefore, people are much more driven to avoid losses than to potentially achieve gains.
As financial advisors and investors, it’s essential to constantly maintain awareness of our own and others’ innate emotionally-driven nature and how it is consistently at odds with sound investing decisions.
Warren Buffet’s famous motto, “be fearful when others are greedy, and greedy when others are fearful,” demonstrates the necessity to resist our natural responses and often do the exact opposite of what our instincts dictate when investing.
So, knowing this, how can we understand our decision-making process, navigate our emotions, and still make healthy financial decisions? Let’s discuss a few research-backed methods.
How to Navigate Emotional Decision Making and Money
Build awareness of your own decision-making process
Awareness is the first step of any personal change. To build awareness, we can leverage a useful method devised by executive coach and Forbes Council member Svetlana Whitener. Whitener asserts that we act on feelings and that all feelings have a root emotion. Using Paul Ekman’s Emotion Wheel, Whitener outlines a five-step process to systematically build awareness of the emotions underlying your decisions:
- Name what you are deciding. You don’t need the Emotion Wheel for this, but you do need to consider exactly what the problem is and the ramifications of your proposed solution.
- Recognize and name all feelings you are experiencing in connection with the decision. These feelings will no doubt appear somewhere on the outer circle of the Emotion Wheel.
- Bring your feelings inward through the middle circle to identify its root cause (an emotion).
- Process that emotion, not one of its symptoms (a feeling).
- Be aware of whether you want to make a decision from this specific emotion or if you want to adjust the course.
This formula may sound somewhat robotic, but it adds structure to an otherwise abstract, unconscious process. With practice, we can recognize just how significantly our emotions affect our decisions and adjust them accordingly.
Use time to distance yourself from emotional responses
A study titled Emotions and Decision Making concludes that the simplest strategy for minimizing overly emotional decisions is to let time pass. Our initial emotional reactions don’t last long, and our bodies and minds are designed to return to a baseline level after just a few minutes or hours, at most.
Dr. Brad Klontz, a financial psychologist at Creighton University, says, “The goal is to put some time between your impulse to act and your behavior…If you can put some time in between those two things, you are more likely to calm down your emotional brain, engage your rational brain and make a good decision.”
The logic center of our brain is five times as slow as the primal and emotional brain centers, so simply allowing time to pass is a psychologically and biologically proven way to make better decisions.
On my Bridging the Gap podcast, I was able to speak more with Dr. Klontz about how our brain and biology often set us up to fail in making decisions about money. Click here to check out the full episode.
Reframe emotional triggers and events
Lastly, the Emotions and Decision Making study gives us one more method that the researchers claim is the most effective: Reappraisal.
“Reframing the meaning of stimuli that led to an emotional response, i.e., reappraisal, has consistently emerged as a superior strategy for dissipating the emotional response.”
Through the eyes of an investor, reappraisal could be useful after the market has a particularly rough stretch of losses. For instance, one might remind themself that losses are normal and to stick to their long-term investment strategy.
Reappraisal is all about taking a step back, considering different ways you could view an event, and then choosing a perspective that minimizes a negative emotional response.
It’s important to note that the goal is not to suppress any emotions, but rather to evaluate which emotions you want to let factor into your decision-making process and to consider which emotions will lend themselves to a healthy decision.
Don’t Shun Your Emotions, Learn From Them
As advisors and investors, we’re often told to remove emotions from our decisions. While that advice is sound in theory, it’s not realistic — we’re human, therefore, it’s impossible to completely extricate emotion from our decision-making processes.
Instead, a more feasible solution involves acknowledging our behavioral biases and performing routine introspection. In turn, we can recognize when and how our emotions influence our decisions, particularly in regard to managing money.
Understanding your clients’ emotions, as well as their triggers, is critical to deepening your client relationships. For a personalized list of other relationship-building techniques, schedule your free session.