I was at an academic conference recently where, as part of a group, I spent a great deal of time thinking about the financial vulnerability of American consumers. Public policy makers, in particular, are concerned that far too many Americans are financially vulnerable. And when we hear statistics like “59 percent of Americans do not have enough savings to cover a $500 or $1,000 unexpected expense,” they are alarming.

What Exactly is Financial Vulnerability?

Sag by Rick Flores Flickr Licensed Under CC BY 2.0
Source: Sag by Rick Flores Flickr Licensed Under CC BY 2.0

It turns out there is no widely-accepted definition of financial vulnerability. I spent the last couple of days looking at the psychological research on this issue and here are my thoughts about how to determine how financially vulnerable you are.

Going strictly by the dictionary definition, vulnerable means “capable of being physically or emotionally wounded.” For our purposes, it is reasonable to define financially vulnerability as “the degree to which a person is capable of being injured financially when an adverse event happens.”

Although many psychologists think of households as being vulnerable, the truth is that financial vulnerability is a property of each person, not a family or household. Within a single household, a child will be more financially vulnerable than its parents, and the primary income earner will usually be less vulnerable than a spouse who earns little or no income.

Many researchers, and especially the popular press, tend to cast financial vulnerability in “either-or” terms: A person is either financially vulnerable, or they are not. It seems to me, however, that it makes more sense to think of financial vulnerability as analogous to a credit score. We can imagine each one of us has a financial vulnerability score. Someone with a score of 90 is extremely vulnerable whereas someone whose score is 15 is relatively resilient to financial tsunamis.

Wake Up America by Wonderlane Flickr Licensed Under CC BY 2.0
Source: Wake Up America by Wonderlane Flickr Licensed Under CC BY 2.0

A person’s financial vulnerability is a dynamic or changing state. Just as our credit score increases or decreases based on how we handle money, take on new debt, make a late payment, and so on, the consumer’s financial vulnerability increases or decreases as its markers change.

This brings us to the next question. What are the markers that add up to make a person’s financial vulnerability score? Based on the published research, there are two distinct types of markers: psychological and behavioral, that can indicate how vulnerable a person is. (As you read the next section, ask yourself to what extent each of these markers apply to you. That will determine how financially vulnerable you are).

Psychological Markers of Financial Vulnerability

  1. Anxiety. When people fall upon hard times, their anxiety and stress levels increase. Financially vulnerable people have greater levels of anxiety and more consistent anxiety about their financial situation.
  2. Fear, frustration, and hopelessness. What is more, those who are vulnerable don’t just experience anxiety, but they also encounter other negative emotions such as fear, frustration, and hopelessness when their financial state looms large. Such emotions, in turn, has negative effects on health.
  3. Uncertainty about one’s future. Typically, financially vulnerable people tend to be unsure about what will happen in the future. Many of them live paycheck-to-paycheck, spend more than they bring in, and have little or no savings. This can cause tremendous uncertainty about what will happen if some emergency or adverse event occurs. Uncertainty can lead to risky behavior in other life domains like taking drugs, practicing unsafe sex and so on.
  4. Lack of financial knowledge. Financial knowledge takes two forms: (1) knowledge about one’s own financial situation, and (2) knowledge about about how personal finances work (known as financial literacy). In some of my recent research, we have found that not knowing one’s current financial condition (irrespective of how the financial condition actually is) is associated with negative financial behaviors. Financially vulnerable people also tend to have lower levels of financial literacy. Perhaps because they feel hopeless, they tune out from the personal finance domain hurting themselves even more.

Behavioral Markers of Financial Vulnerability

Where the psychological markers refer to a vulnerable person’s psychological state, behavioral markers measure the actual behaviors (and condition) of an individual to determine how financially vulnerable they are.

  1. Low or inconsistent income. People of any income level can be financially vulnerable. However, having consistently low income (below the poverty line, or less than $24,600 for a family of four this year) or having a higher level of income that fluctuates wildly from one month to the next is a marker of vulnerability.
  2. High level of debt. Even people having a high and stable income can be vulnerable if they carry a high debt burden, especially in comparison to their income. Carrying high levels of student loans, outstanding credit card balances, car loans, etc. can increase the person’s susceptibility to being harmed if disaster strikes.
  3. Irregular employment. Related to small or inconsistent incomes is the nature of the individual’s employment. If the person’s employment varies frequently, or even if their job is stable but their number of hours worked differ from one week to the next, chances are that it introduces instability into the person’s financial life, and makes them vulnerable.
  4. No margin of safety. As many surveys and popular financial advisors like Dave Ramsey point out, an emergency fund of 3-6 months of income provides a cushion against financial surprises, and reduces stress and anxiety. Those who do not have an emergency fund and whose spending level is very close to or exceeds income are more financially vulnerable.
  5. Social support. Even when everything is going bad financially, people who have family or close friends who will provide them financial support are financially resilient. Their social circle will help them bounce back. In my research, I have found that such people feel “cushioned” or protected, and tend to make financial decisions with greater confidence.

At its heart, a high degree of financial vulnerability is a sign that the person’s financial situation is unstable, and there is no margin of safety in their life. I do not think there are any easy answers about how to become reduce financial vulnerability. However, knowing its markers, and learning that at least some of them such as understanding our own financial condition, and avoiding taking on more debt, are within a person’s control, is the first step towards reducing financial vulnerability.

About Me

My book titled “How to Price Effectively: A Guide for Managers & Entrepreneurs” is now available either as a free PDF or for purchase from Amazon. I teach marketing and pricing to MBA students at Rice University. You can find more information about me on my website or follow me on LinkedIn, Facebook, or Twitter @ud.

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