The psychology of financial panic

Having trouble investing wisely in today's tumultuous market?

The problem may be your brain.

Brad Klontz, a Hawaii-based psychologist who specializes in financial disorders, says that thanks to lessons we learned as cave dwellers, human beings are psychologically pre-programmed to deal irrationally with financial shocks.

We flee in the same direction as the rest of the tribe, because at some deep level we believe that if we don't, we're going to get trampled or eaten, he said. And we're so emotional: 80% of the gray matter in our brains is dedicated to dealing with feelings. Just 20% is analytical.

Under normal circumstances, the analytical mind directs the emotional mind, a balancing act he likened to a performer (your analytical brain) riding an elephant (your emotional brain).

"That works really well until the elephant gets scared," Klontz said. "At that point, the elephant is going to go wherever it wants."

So what should you do?

Face your fear

The first problem people have when dealing with financial fears is their predisposition to react, said Rick Kahler, a fee-only financial planner and a coauthor of several books on the psychology of money. When dealing with a fearful situation, humans typically respond with one of the three Fs -- fight, flight or freeze.

Often, they react before they even think about why.

Instead, Kahler said, you need to recognize that you find the situation frightening and wait at least 20 minutes before doing anything, he said.

Why? Your body floods your brain with chemicals when you're frightened, which makes it difficult for the analytical side of your mind to function. You need to recognize that this chemical flood is making you overly emotional and let it recede before you react.

Is your fear rational?

It's rational to be fearful about a falling stock market if you're going to need the money soon, or if you've invested in companies that seem to be headed for bankruptcy.

But fear about a stock drop when only long-term money is in the market may not be rational. That's because you may have enough time to let the market climb back. If you have the resources to save more, or have the ability to create another contingency plan, you will be more likely to survive the storm.