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How to keep a cool head during volatile times

September 23, 2011, 5:23 PM UTC

By Eric J. Dammann, Ph.D., contributor

FORTUNE — As the markets roil and uncertainty hangs over the economy in ways we haven’t seen since 2008, it’s a good time to address how all the turbulence has impacted investors’ psyches. Money and psychology are inextricably linked, of course — it’s the reason people often call the markets “skittish” to explain drops with little cause. And fear and panic are the main emotions that drive investor selling, almost always irrationally (see yesterday’s 391-point drop in the Dow as an example).

But what most investors don’t realize is that in addition to collective market psychology, almost everyone has his or her own individual psychological issues with money. While crashing stocks, ballooning mortgage payments, or the threat of job loss are understandable causes of stress, our more significant problems with money stem from our own internal issues that drive many people to act irrationally when it comes to financial matters — whether there’s a market crisis or not.

The most obvious examples of these issues are the classic money-related pathologies we’re all familiar with: gambling addiction, overspending, hoarding, etc. But there are many more subtle everyday examples — the inability to deal with day to day financial tasks, falling for get rich quick schemes, taking on excessive debt, and the inability to attend to important long-term financial issues like estate planning.

Irrationality with money plays a big role in families, too: the myriad subtle and unintended messages parents give to children regarding money, or relationship problems that can arise over insignificant amounts of money. In a significant number of divorces money is a central issue, and many problems with settling a divorce amicably are money related.

Interestingly, irrationality with money is also evident on a national level, as evidenced by the ongoing financial crisis, during which many of our largest financial institutions and regulatory agencies made decisions that, in hindsight, were clearly problematic and avoidable.

So if it’s true that we all have money issues, how do we correct them? The first step is to identify what money means to you—what it really means to you.

According to Webster’s, money is:

1: something generally accepted as a medium of exchange, a measure of value, or a means of payment: as a: officially coined or stamped metal currency

2: wealth reckoned in terms of money b: an amount of money

3: a form or denomination of coin or paper

But this definition, while accurate, doesn’t quite get at what money actually means to many people. An easy way to begin to understand your own relationship with money is to answer the following question:

money = (fill in the blank)

When I’ve posed this question to workshop participants, they’ve been amazed at how large and varied a list they create. Some of the most common answers are: control, love, power, security, safety, independence, freedom, social acceptance, and sexual appeal. Another easy test is to identify how money is being used, and you’ll have a sense of what it means. For example, money can be used to show love, to punish, to foster dependence, to manipulate, to humiliate, and to create alliances.

But whatever the answers, none of the above-mentioned definitions are the same as the dictionary definition; so the next obvious question is, where do these meanings come from? In my experience, most of these additional associations with money develop during childhood.

Children learn about money from a variety of sources, but as is the case with many psychological issues, our parents have the greatest impact; specifically, it’s the parent’s indirect messages that are often the most powerful. As we know, children are sponges, taking in the myriad interactions parents have around money everyday, many of which we don’t even pay attention to. Every time we lie about our child’s age to get the cheaper movie ticket, or argue with our spouse about the price of a recent purchase, we are sending a message — often one that’s contrary to the conscious message we intend to send.

What parental behavior, for instance, might lead a child to later equate money with control? Consider the parent who uses an allowance to reward or punish behavior; one of my clients knew he had to behave especially well on Sunday (the day he got his allowance), because if he annoyed his mother on that day she wouldn’t give it to him. What about equating money with love? The most common way this gets established is when a parent, perhaps due to guilt over being away from home for business trips, returns home and showers the child with gifts.

These types of interactions on an occasional basis are not necessarily problematic. But when repeated over time, these early experiences can solidify into firmly-held beliefs. And because they’re developed through the eyes of a child, they tend to be incomplete or partially true, but yet they become indelible, controlling the way we interact with and use money. Some authors have called these beliefs “money myths” or “money wiring,” but I prefer the term “money scripts,” because they control our actions just like a script does in a play (this term was first coined by psychologists Brad and Ted Klotz and financial planner Rick Kahler).

One of the most common scripts is “money is bad.” It’s important to note that these beliefs are sometimes true, and it’s easy to find evidence to support the notion that money is evil. In many divorce proceedings, for instance, money is used for evil purpose, and an awful lot of violence is perpetrated in the name of money. But there is evidence for its opposite as well (the Bill & Melinda Gates Foundation, for example). Someone with the money script “money is bad,” however, will see all money as bad, and will therefore avoid things having to do with money. This is the person who sees money as dirty, or who ignores money by not opening their monthly statements, not doing an estate plan, or meeting with a financial advisor.

Another common money script is “more money will make things better.” If one is in abject poverty, and can barely afford food and shelter, there is no question that more money will make things better. But once we have reached a level of income that takes care of the basic necessities of life, more money does not necessarily make things better, and in fact for some people excess money can actually made things worse. This script can lead to problems like workaholism, or the disillusionment many feel once they have “made it” financially.

A third important script is “There will never be enough money.” This leads people to hoard out of fear, and is evident in the person who is not willing to take appropriate risks when investing, or keeps everything in cash. Its also evident in those wealthy people whose money is a source of constant stress rather than fulfillment. They simply cannot use their money wisely, because any use of money feels dangerous. It also leads to panic selling, when dips in the stock market feel like the person’s money is being taken away.

A final common script is perhaps one of the most pervasive, the script of “money equals self esteem.” This is the person who equates their net worth with their self-worth, and therefore feels terrible about themselves when the Dow starts falling. This can also lead to the excessive acquisition of material things in order to feel better about oneself.

One final aspect to notice about many of the money scripts I’ve discussed is that they can be flipped. For example, the preceding “There will never be enough money,” is for some people “There will always be enough money.” This script is, I believe, the source of much of the current mess we are in, leading people to believe that real estate values will keep going up, or that they can continue buying things on credit and the money will magically appear from somewhere. These are also the people who take excessive risks when investing.

Now that you have an understanding of money scripts, try to uncover which are relevant to you. What are the overarching beliefs about money that govern your interactions with it, and how might these be influencing your current behavior and emotional reactions to the crisis?

Once you have a clearer understanding of what money means to you, you are in a better position to weather the inevitable ups and downs of the economy, and to see that often the main source of financial stress is actually not the economy; it’s our distorted relationship with money and how it impacts our ability to deal with the crisis. Awareness of money beliefs is the first step; it will allow you to modify those beliefs to fit the current situation, and thereby deal with money more objectively.

To conclude, money is an excellent tool, but only when used appropriately. You wouldn’t use a hammer to cut a two-by-four, but we often attempt to use money to achieve things for which it wasn’t designed. It can, however, help us to achieve our goals if we use it with care and understanding. When you demystify money, and remove the inappropriate meanings and emotion from it, you are in a better position to use it wisely and purposefully for the betterment of yourself, your family, and your community — in times of crisis and beyond.

Eric J. Dammann, Ph.D. is a clinical psychologist and psychoanalyst with a private practice in Manhattan. In addition to his clinical practice he is a consultant to individuals and organizations interested in understanding the psychology of money and finance.