Here's What Financial Trauma Does to Your Brain
Overcoming past financial trauma is essential to a healthy, prosperous relationship with money
Trauma is the emotional response to a deeply upsetting event. It can break down your mental resiliency and leave you feeling helpless.
There are many different kinds of trauma, including financial trauma. Money-related events that were so devastating that they continue to impact our relationship with money months or even years after the fact.
This is another installment in my ongoing series called “Money On My Mind,” where I publish articles to help you deal with the psychological aspects of managing money. Check out past editions of the series here.
Continue reading to learn:
How past financial trauma can impact your financial decision making
The science behind trauma and how it affects the brain
How feelings of financial shame manifest in poor money decisions
How to overcome financial trauma and live a happier, richer life
(Quick reminder: My book, The Rational Investor, launched on Monday, If you haven’t already, pick up your copy here.)
Financial trauma and personal finance
“Time heals all wounds.”
That’s a quote you’ve probably heard many times in your life. But, when it comes to trauma, it’s not necessarily true. Yes, the more distance you have from a traumatic event, the less acute pain you’ll feel daily.
However, if left untreated, traumatic experiences with money can stay with you your whole life and impact your relationship with money without you even realizing it. A 2021 study found that those who experienced childhood trauma were more likely to experience food and housing insecurity as adults.1
Traumatic financial events lead to poor money management decisions.
Trauma wreaks havoc on our brain’s decision-making infrastructure—more on that in a minute. To be clear, this is not an issue that can be solved by financial literacy alone. Yes, you need to know how money works to make good financial decisions, but trauma can distort your decision-making process, even if you are a pro with money.
A 2012 study examined 1,100 financial planners to find out how the 2007-2008 financial crisis impacted their beliefs about the right way to manage money.2
93% of planners during the crisis reported high levels of stress
Nearly 40% experienced post-traumatic stress symptoms
If you think that nearly half of financial planners experiencing post-traumatic stress symptoms feel strange to you, put yourself in their shoes for a moment.
It’s difficult to understate how scary the headlines were back in 2008. We were closer than many people care to remember to a complete meltdown of the global financial system and a depression-level financial catastrophe.
If you’re a financial planner who gets paid a percentage of the assets you invest on behalf of your clients, your income would be in freefall as the stock market, and your client’s portfolio gets chopped in half over an 18-month period. In addition to your income getting hit, your wealth would be falling just as fast as your clients.
Perhaps worse than the financial pain is the emotional stress. Imagine spending 12+ hours per day trying to explain what is happening to your clients who are scared, angry, and confused about what’s happening. Many clients would blame you and hold you personally responsible for what’s happening. Even if you do everything by the book and have your client’s in an appropriate portfolio, intense feelings of guilt and shame would be unavoidable.
For financial planners during the financial crisis, their livelihood, reputation, career, and mental health were all on the line; this was, undoubtedly, a traumatic event.
So, how did the trauma of the financial crisis impact how financial planners manage money?
In that 2012 study, the researchers found that post-financial crisis, planners became much more likely to abandon sound “buy and hold” investing strategies in favor of making more active decisions like market timing and stock picking.
83% of planners were found to make at least one “active” portfolio management decision in the next few months after the survey.
Nearly two-thirds of planners believed active investing is superior to buy-and-hold passive investing using index funds.
Why does this matter? Financial planners taking an active role in managing their client’s portfolios sounds like a good thing. After all, isn’t that their job?
Not exactly.
Their job is to do what is best for the client. There is an irrefutable amount of evidence that investors who adopt a buy-and-hold passive investment strategy outperform active investors who try (and fail) to pick individual stocks or time the market. To plug my book again, I discuss this evidence of buy-and-hold vs. active investing in The Rational Investor.
I have always known that financial planners consistently engage in active investing strategies which are harmful to their clients’s wealth. In the past, I attributed this to the financial planner’s financial incentive of recommending high-fee investment funds. However, this research suggests an additional reason for this irrational preference for active funds; financial planners suffer from trauma lingering from the financial crisis.
The events of 2007-2008 were so traumatic that planners felt the need to take a more active role in portfolio management in a —misguided— attempt to avoid the consequences of another 2007-2008 style crash. As the researchers point out, the paradox is that in their attempt to avoid another traumatic financial event, active management only makes it more likely since buy-and-hold strategies lead to better outcomes.
If financial trauma can lead well-educated, experienced financial professionals to make irrational financial decisions, you can bet it does the same to the rest of us.
Here’s what that means for you.
If you want to be better with money, financial literacy alone won’t be enough. You need to identify and move past any financial trauma that might be impacting your decision-making process.
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Trauma breaks down the road’s within the brain
A 2018 paper titled “The Impact of Psychological Trauma on Finance” brilliantly explains how traumatic experiences erode the brain’s ability to make rational financial choices.3
The researchers compare how the brain receives information and moves it to other parts of the brain to decide what to do with that information to a network of roads in a city. In the same way, we use roads to drive from our home to the office, the brain uses “neural networks” to move information to different parts of the brain that, in turn, interpret that information and formulate a response.
The impact of trauma is like a city deciding to slash the maintenance budget for local roads. What happens to roads when we don’t repair them?
They begin to break down.
The process can be slow at first, but over the years, cracks begin to form, which turn into potholes, and before you know it, you can’t even drive down the road without risk of destroying your car.
Think about what happens when the main traffic-bearing roads in a town become undrivable; increased traffic, slower movement of goods and people, and eventually a dysfunctional community.
As Pointed out in a 2014 paper, untreated trauma causes portions of our brain to become rigid.4 The roads that our brain wants to use to process certain information become congested.
Eventually, parts of the brain can even become “chaotic.”
Returning to our example of the main roads in a town becoming so badly damaged that people can no longer safely drive on them. This forces traffic down random sidestreets neighborhoods that were not intended to act as main traffic hubs. Instead of a simple A to B drive down Main Street, you find yourself lost in a confusing web of streets you’ve never traveled before. These streets are filled with other confused and impatient drivers and local residents who are not happy with the uptick in local traffic.
A simple drive now takes longer to complete and has become confusing and frustrating. That’s the type of chaos that untreated trauma causes the brain. Processing certain information becomes slow and chaotic.
Financial shame
One way in which people respond to financial trauma is to feel shame.
If you were one of the millions of people who lost their homes in the 2007-2008 financial crisis, that is a traumatic financial event. I would know; my parents lost their home—the house I grew up in—when I was 21. That event and the resulting fallout were traumatic and certainly led to feelings of shame for all of us.
It’s hard to lose such a publicly visible symbol of your financial success and stability. Returning to the paper by Ross and Coambs (2018), they outline four types of financial shame.
The inability to communicate about money. You feel shame to talk about your financial needs, desires, goals, and struggles.
Not seeking out information about how to manage money.
Feeling financial mistakes are the worst types of mistake you can make. Financial shame can lead to a need to feel like you can never make financial mistakes. In a previous post, I covered how the unrealistic expectation for yourself can lead to a toxic thought spiral, resulting in destructive behavior like blaming yourself or others for your financial struggles.
Feeling like you don’t have the right to feel financial pain or have ambitious financial goals.
Shame has the devastating duel impact of preventing you from making changes to your financial decisions while causing significant pain and even more shame when you make a mistake.
The more mistakes you make, the more shame you feel and the less likely you are to make a change or ask for help. It’s a vicious cycle.