How to help clients break old habits

Sarah Newcomb, Behavioral Economist at Morningstar U.S. on how advisers can help clients get a fresh financial start.
By Morningstar |  26-04-17 | 

Everyone’s heard the horror stories: lottery winners who go broke a couple of years after the big jackpot, celebrities in bankruptcy court, or pro athletes who’ve squandered their millions and live on the street. These extreme cases are examples of a much wider behavioral phenomenon, one that covers not only people with sudden millions, but also recent college graduates who are flush with cash after getting their first real job or small business owners whose hard work finally pays off after years of squeaking by.

 People who come into money need good advice to turn their money into wealth.

 “They’ve never been in that situation before, and it can be quite shocking,” said Morningstar behavioral economist Sarah Newcomb, Ph.D., author of the forthcoming book Loaded: Money, Psychology, and How to Get Ahead without Leaving Your Values Behind.

To help advisers navigate new-money situations and talk about them with clients and prospects, we asked Newcomb about the psychology behind new-money behavior, and how advisers can help.

Everything is amplified

“Money turns up the volume on everything,” Newcomb said. “Let’s look at someone just coming out of college. Suddenly you find yourself with a paycheck that’s bigger than you’ve ever had before, and you don’t quite know what to do. One of the biggest things to recognize is that you’re now going to have a lot more ways to either do great things or get yourself in trouble.

“If all your extra money and all your extra time during college was spent in certain ways, then just having a new job isn’t necessarily going to change the way that you’re spending money. It’s just going to give you more opportunity to spend more in the same old ways.”

For advisers, breaking down bad habits and demonstrating the need for early career long-term planning can cement client relationships and build the trust that’s crucial to every advisory relationship.

It’s not need versus want

“I really don’t like the idea that people need to know the difference between a ‘want’ and a ‘need.’ We need to know the difference between a need and a strategy for meeting that need,” Newcomb said. “We always hear about how if we didn’t go to the coffee shop every day we could save like $1,600 a year. Everybody hears that and says, ‘Oh that’s awesome. That would pay for my whole health insurance premium.’”

In practice, making that happen isn’t so easy, and advisers should beware of quick fixes that don’t address a client’s real needs.

“Making coffee in the office might work for a day or two, but the reason you go to the coffee shop probably has nothing to do with caffeine,” she said. “You’re probably meeting a different need than a need for caffeine. You find yourself back at the coffee shop.

“People don’t go out to eat dinner because they need food. They do it because they want to connect with friends or experience something novel. They’re meeting needs for social connections, for convenience. If you cut something out of your expenses without tracing it back to the need that you’re meeting, the expense goes away but the need doesn’t—it stays there and gets louder and louder until you finally meet it.”

Good budgeting, then, will restructure financial priorities to meet a person’s needs in a way their current finances can handle without also sacrificing future security, giving your clients more money to invest toward long-term goals.

The status trap

New money can also mean new pressures as people try to “keep up with the Joneses” and feel like they have to spend money to demonstrate their new status. Newcomb said that the trade-offs between spending for today and focusing on the future can be made more easily when your clients understand that most everyone else struggles with the same decisions—and they aren’t necessarily making good choices. Advisers can help solve this dilemma by pointing out some key facts.

“We have to recognize that the people around us who seem like they have it all probably don’t,” Newcomb said. “For example, the American Psychological Association does a stress survey, and every year since it started doing the survey, regardless of the economic climate, regardless of whether it was recession or boom, money is the top source of stress for people.”

In the APA’s 2014 survey, 72% of people reported being moderately or extremely worried about money, and a separate study showed that 62% of people were literally losing sleep over their finances.

 “You can see people going out and spending and driving great cars and living in great houses and always having the new gadgets, but remember that six to seven out of every 10 of them are also losing sleep over their money. I think that can help when you’re considering your own trade-off and say, ‘Who do I want to be? Do I want to be the guy that looks like I have it all, but it could fall apart any second? Or do I want to be the one who’s got his head on straight and has real security?’ Be the guy whose friends ask him for financial advice. That’s real status.”

 The time value of money works both ways

Persuading clients with new money to invest for the long term can be difficult, but Newcomb pointed out that the time value of money works in two directions—and that can be quite a reality check.

“People—young people especially, need to also take stock of their long-term needs, like the need for financial security. They’re 22 and they get out of undergrad, or they’re 25 and get out of grad school, and they get a job and say, ‘I’m 25 years old, I do not need to start saving for retirement now,’” Newcomb said. “But at 3% inflation, the historical average annual inflation, prices on everything double every 24 years. If you get out of college at 22 and the lifestyle that you’re comfortable with costs you $50,000, by the time you’re 46, that exact same lifestyle will cost $100,000 a year. At 70, the lifestyle that cost you $50,000 when you were 22 will cost you $200,000 a year.

“The time value of money works against inflation, so we have to counter that. People think about how much their lifestyle’s going to cost them on day one of retirement, but they forget about year 25. They end up in their 90s on a fixed income, which essentially means their buying power is going down every single year.

“That’s why you have to start with, ‘What lifestyle do I want to live? What will be comfortable for me? What will that cost me in the future?’ When you really start looking through numbers then you say, ‘Oh crap! I have got to start saving.’”

The key, then, is for advisers to reframe this reality by helping clients identify what’s important to them and what lifestyle they want for the future. Then, advisers can work backward from that to find a present-day plan that takes those goals into account.

Build the skill of saving

Even after recognizing the needs that drive them, it can still be tough for advisers to help people break bad habits if they aren’t used to saving money. But learning to save, especially in new-money situations, is essential.

“We tend to think, ‘I’m either a spender or a saver.’ Saving is a skill,” Newcomb said. “You don’t say, ‘I’m going to become a runner,’ and start by signing up for a marathon. You start by running around the block, because it takes a lot for your body to build endurance. You have to do it slowly over time, and it’s the same with saving.”

Advisers and financial planners can play a crucial role here as a coach or personal trainer, strengthening these essential saving habits and getting clients ready for the long race ahead of them.

“If you’re naturally a spender, you’ll tend to associate money with things like freedom and opportunity and fun, and you’re thinking about all the things you can do with the money. It’s those experiences that you’re looking for, rather than the feeling of saving. Saving feels painful, because if you are a spender, saving means that you’re not getting the stuff that you want. You feel like you’re depriving yourself.

“If you are a saver, on the other hand, you probably associate money with the feeling of security and safety, and you feel more free when you have money in the bank than when you’re spending your money. Savers are lucky people who naturally just love holding on to money--they don’t need to build the skill of saving. They understand that. Those of us who are spenders, we have to slowly build it up.

“You don’t go from being a spender to having a down payment on a house right away. You do it little by little, by training yourself to save. It’s like exercise rather than dieting: You build your strength over time.”

Turn income into assets

While a new income might be nice, it can be fleeting if your clients don’t harness it to build wealth and meet future needs. Once your clients are sold on the idea of making financially healthy changes, then advisers can start the process of explaining the difference between income and assets.

“There are three sources of income: land, labor, and capital,” Newcomb said. “If you ever want to get to a point where you can stop working, you have to have other assets to generate income and replace your labor. That’s as simple as money management gets.

“If you think in terms of income, you’re always thinking about the stream, but if you think in terms of assets, you’re thinking about the source of the stream. Assets generate income. When you first graduate, those assets are your mind and your degree, and you’ve got to use those because that’s your source of income. You can have a high income but if you’re not growing your store of assets, then you will always have to work in order to have that income. If you’re growing your store of assets, then you’re making it so that someday you don’t have to work.”

Kick-start change with the fresh start effect

As a clear financial plan comes into focus, advisers can use what behavioral scientists call the “fresh start effect” to make a client’s new financial outlook stick in their minds.

“When we think of something as being a fresh start, we are naturally motivated to put our best efforts into reaching our goals,” Newcomb said. “That fresh start can be the start of a week, New Year’s, a birthday, the start of a season,” or another landmark in time.

Research clearly supports this: In a study done by Wharton University scientists, people were asked to describe a goal that they would like to accomplish, then they were asked when they would like to get an email message reminding them of that goal. Some of the participants were given the option to choose the first day of Spring as a date for the reminder; others were given the option of choosing the third Thursday in March. Those both occurred on the same day, but participants overwhelmingly chose the first day of Spring.

“It’s worthwhile to take advantage of the fresh start effect and not ask, ‘Fresh start with a fat new pay check, what do I want to do?’ but instead, ’Fresh start with a lot more opportunities. Who do I want to be?’”

More than numbers

In the end, Newcomb said that financial planning goes beyond spreadsheets and charts, and that advisers who understand their clients’ lives and motivations have the best chance of getting through to them.

“So much financial advice consists of numbers and ‘shoulds.’ But the reality is that we make all of our financial decisions in the larger context of our emotions, our desires, our sense of identity, and our desire to be accepted,” Newcomb said. “Very little of it really has to do with numbers. It has to do with these stories that we’re telling ourselves and the stories that we want to believe about ourselves.

“Ask, ‘What are the needs that I’m meeting?’ and be brave about answering those questions in real life. We do a lot of things with our money because we want other people to like us. We’ve got to admit that and then say, ‘Okay. Now how much am I willing to spend for others to think I’m awesome, and how much is just not worth it?’“

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