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Struggling financially? The stress might hurt your decision-making

One of the tenets of the “American Way” is that anyone can “make it,” no matter how dire their circumstances. While this is a comforting thought, the reality might not play out quite so nicely. According to research from the University of Massachusetts, Amherst, there are indications that financial stress can reduce the ability to make good long-term decisions.

In situations where financial insecurity is a problem, researchers Christian Weller and Amy Helburn found that study participants had a harder time making financial decisions that would benefit them in the long run. Ultimately, financial stress and insecurity can lead to a cycle of financial difficulty because of the way it impedes our ability to make sound financial decisions.

Financial hardship = poor long-term financial decisions

After identifying households with and without financial stress (using assets and poverty income as measures), the researchers used statistical models to compare stress responses. They found that signs of stress in households with lower assets and higher levels of financial insecurity were 14 percent higher than the responses in households without the same level of financial insecurity.

The effects of higher stress in poor households appeared to reduce the ability to make good decisions. Weller and Helburn found that low asset levels lead to behaviors that were risk averse [3], and that long-term decision-making could be affected:

More financial stress reduces the probability that a household saves for known, major future expenses, that it increases a household’s leverage, and that it raises a household’s relative cash holdings.

In the long-term, all of these phenomena conspire to slow wealth-building efforts. The ability to save for major future expenses is important, since it can help avoid a financial crunch down the road. Indeed, part of the reason that leverage is higher in poorer households might be due, in part, to failure to save for future expenses leading to a need to turn to debt to finance these costs, feeding a vicious cycle.

Isn’t ‘higher cash holdings’ a good thing?

About those “higher relative cash holdings”; at first glance, that might seem like a good thing. But it’s important to note that the cash holdings are relative┬áto other assets. It doesn’t mean that the subjects have a pile of cash just sitting there; it means that those with low assets have more cash than they should, relative to other asset holdings like stocks.

Indeed, the study found that those who are financially insecure are more risk averse. This means that, rather than using some of their assets to invest in stocks (even index funds, which offer a lower-risk way to invest in equities), those in insecure households instead stockpile cash. In a low-rate environment, it is especially hard to build the wealth needed to break the poverty cycle when most “investments” are in cash.

The researchers concluded that financial stress might contribute to growing wealth inequality [4] in the U.S. Since those in secure positions are more likely to engage in the actions that secure them further, and those in less secure positions are likely to make poor long-term financial decisions, the cycle perpetuates itself.

So how do you break out of a difficult financial situation? Contacting a certified nonprofit credit counseling agency [5] might be a good start. They can look at your financial situation with fresh eyes, and may be able to suggest a course of action that can help you find your financial footing.

What do you think? Is it hard to break out of a tough financial spot? Can stress brought on by financial difficulty make financial decision-making worse?
(Photo: Flickr user Eamon Curry)