How to avoid making 'permanent mistakes' with your money: Financial psychologist

If you're headed for a divorce, you may be headed for worse outcomes in your portfolio as well. At least, that's what a working paper from researchers at UCLA suggests.

The researchers studied the habits of stock traders in Finland, a country that provides useful data on this front because couples there rarely have joint investing accounts.

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The most active traders among the investors, all of whom divorced between 2000 and 2014, did well for themselves in the 4 to 5 years prior to their breakups: Stocks they bought gained an average of 8.9%, while stocks they sold gained 5.8%.

But in the three years leading up to a divorce, traders' returns went off the rails, with their stock purchases returning 0.6% on average compared with the 2.6% average return on equities they sold.

Financial psychologists say the data shows the negative impact major external stressors can have on money decisions. And you don't have to be a Finn in a failing marriage to fall into this trap.

"When we become emotionally flooded, we become rationally challenged," says Brad Klontz, a certified financial planner and financial psychology professor at Creighton University. "We've all had that experience where we're yelling at someone and then later on, think, 'I can't believe I said that.' Divorce is an ongoing heightened emotional experience."

Letting emotions take control in situations where you need to make rational decisions about your long-term wealth can be costly, Klontz says. "Emotional responses can lead to decisions you can't take back. You have temporary stress. Don't make permanent mistakes."

Here's how experts say you can avoid stress-related money blunders, especially ones that can have an outsized impact.

How stressors and cognitive biases can affect money decisions

Major stressors, such as a divorce, impair decision-making by hogging all of the real estate in your brain, says Michael Kothakota, a therapist and certified financial planner.

"You make worse decisions when you're depleted. Even if you're just tired at the end of the day, research has shown you're less likely to eat well. You're less likely to exercise, if that's a goal of yours," he says. "If you're getting divorced, you're constantly depleted. It becomes incredibly difficult for the part of your brain making logical decisions. You might make an error that costs you thousands."

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The first step to avoid such errors is to recognize that we're all prone to emotional decision-making, even if we consider ourselves cool-headed when it comes to money, says Kothakota. "People shouldn't labor under the delusion that emotions don't influence their investing decisions." That misconception "affects even the best traders."

When undergoing a high-stress situation, investors tend to fall prey to two major cognitive biases, experts say.

1. Negativity bias

When things are going badly, people tend to expect the worst. "We have this bias because it helped us survive," Kothakota says. "You tend to take more note of a tiger in the jungle because it could possibly eat you."

If you have a negative view of an event in you life, you're prone to view investments that way as well. That could be as simple as taking negative views of investments you associate with the stressor. "My spouse works for AT&T, so now I have a negative view of AT&T. Now I'm thinking less objectively about that investment," says Kothakota, by way of an example.

Even for investments to which you don't have a direct emotional tie, focusing on the bad can cause you to see it everywhere you look. "Because of this traumatic event, you're going to spend more time focusing on the negative aspects of the news you see," Kothakota says. This could cause you to sell investments that are undergoing temporary setbacks, instead of hanging on or buying more.

2. Loss aversion

Like many other stressors, divorce is a form of loss — of your spouse, time with your children, and possibly, a portion of your wealth. When this happens, people tend to try to hang on to what they have, which can result in financial mistakes, says Klontz.

"Maybe you belong to a gym or social club that you can no longer afford, but you don't want to admit to your friends or yourself that that's the case," he says. "Trying to avoid the pain of that loss is so powerful that you put yourself at risk."

The same bias could compel you to hang on to losing investments, or, if you've lost a particularly large sum of money, to pursue risky measures to recover it. "I get questions like this all the time," says Klontz. "They say, 'I'm recently divorced and I have this much money. How can I double it in a year?'"

How to protect your money during stressful times

If you're going through a difficult period, the best financial decision you can make may be to not make any significant decisions at all. "Do nothing. That's essentially the message," Klontz says. "It's almost like coming into a large sum of money. Don't quit your job, start a business, or invest in your friend's company. Put some time between your emotional response to the event and any action you might take."

Some financial decisions can't wait, especially if your money is wrapped up in whatever stressful scenario you're undergoing. In those cases, it pays to talk to a professional who can help you put things in perspective and take emotions out of the equation, says Kothakota.

"Consider seeing a pure therapist, or a financial therapist who understands how people make decisions with their money," he says. "If it is a divorce, a certified divorce financial analyst can help. Talking with someone with experience can help."

That goes for any event that ushers you into uncharted territory, says Klontz. "When you're facing a big transition, it can be helpful to enlist a guide who has been down that path," he says. "They think about things you don't think about, mistakes you're prone to. It's just another way to calm down the animal brain and put time between the impulse and your action."

The article "How to Avoid Making Permanent Mistakes With Your Money, According to a Financial Psychologist" originally published on Grow (CNBC + Acorns).

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