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Divorce & Financial Risk: Risk Tolerance Takes an Unexpected Turn

Divorce is a life-altering event that has many effects on lifestyle including emotional well-being and financial stability. There is a significant threatening trend observed after divorce that is the paradoxical change in financial risk tolerance among both men and women. Despite facing a significant change in standard of living, individuals tend to engage in riskier behavior financially, socially, and with lifestyle choices. This article dives into some of the reasons people engage in riskier financial behavior and the importance of understanding and managing risk tolerance post-divorce.

Post-divorce standard of living change

Following a divorce, statistics reveal that women, on average, face a 30% decrease in their standard of living. For women above the age of 60, this percentage rises even higher to 45%. On the other hand, men experience a 10% reduction in their standard of living after divorce, with the percentage increasing to 21% for men above 60. While at the same time on average credit card spending and debt is driven higher, while budgets get stretched. In addition, investment accounts tend to take on higher risk with the idea of chasing returns when in fact the risk level should be lower to account for the change in lifestyle. These significant changes in financial standards cause major stress points, leading to the question of why risk tolerance increases amongst those who get divorced instead of decreasing.

Understanding the underlying risk drivers

The viewpoint of newfound freedom and “being free to do what I want, when I want” often develops after a divorce. This mental shift fuels a willingness to take greater risks, leading to riskier financial decisions, increased spending, and indulgence in social and lifestyle behaviors. Behavioral finance and social studies theories have shown that individuals tend to exhibit a higher risk tolerance after divorce, contrary to what might be expected given the reduced means of a single-income household.

When we look back, marriage is often viewed as a safety net when it comes to financial risk. Dual incomes provide stability and a buffer against unforeseen financial setbacks. The ability to combine resources enables couples to take on more investment, and lifestyle risks confidently. However, in the aftermath of divorce, the safety net disappears, leaving individuals vulnerable to financial uncertainties and the need to reassess their risk tolerance.

Furthermore, the act of divorce itself is recognized as risky behavior, with the outcome being unknown and potentially life-changing, compared to staying in the marriage continuing the status que. Engaging in one risky behavior can trigger a domino effect, making individuals more tolerant of risk in other aspects of life. Additionally, the emotional toll of divorce may lead to coping mechanisms that involve impulsive decision-making, further contributing to accepting and seeking a higher risk tolerance. This higher acceptance of risk levels is also translated to investment accounts, when in fact it should be the opposite.

Adjusting the risk to compliment lifestyle

Understanding the paradoxical shift in risk tolerance after divorce is crucial for financial planning and management. Divorced individuals should take the initiative to reassess their risk tolerance levels, align them with their new financial reality, and set appropriate financial goals. Seeking guidance from financial advisors can aid in making informed decisions and creating strategies to manage risk effectively. Notably when it comes to investment and portfolio allocation. Investments, such as 401’k, IRA’s, and brokerage investment accounts should have an appropriate risk allocation that matches the financial goals, and compliments lifestyle.

If the lifestyle is engaged in “risker” behavior, then the portfolio should take on more of a conservative stance. While if the lifestyle is conservative then that allows for increased risk in the investment accounts. The ability to endure volatility is safer in the short run with a stable and less “risker” lifestyle. While many unforeseen hardships may happen in a “riskier” lifestyle, thus the investments need more predictability, also known as a lower standard deviation.

Always in control

Divorce brings on significant financial challenges, and understanding the changes in risk tolerance that follows is essential for long-term stability. Despite facing a reduced standard of living, individuals tend to adopt riskier financial behavior, which can exacerbate financial hardships. By recognizing this paradox and actively managing risk tolerance, divorced individuals can make sound financial decisions, safeguard their assets, and embark on a path to regain financial security and independence. Seeking professional advice and building a solid financial plan are essential steps towards navigating the uncertainties that lie ahead after divorce.