On May 6, 2010, investors learned a mammoth lesson about the financial markets during a 10-minute free fall in stock and bond prices that came without notice. The possibility of a $1 trillion dollar loss suddenly and unexpectedly turned real (and froze hearts). Nobody could remember experiencing something that happened that fast. Even the 1987 crash took much of a whole Monday.
Like the '87 crash, this one had no known cause, though people are still trying to understand the cause (or causes). It is useful to think of some analogies. If the meltdown in the financial markets in 2008 was like an earthquake, then this was a severe aftershock. Or else it could be likened to a severe roller coaster plunge (one that's much less fun). And obviously, the shock might have been greater for somebody older. A 30-year-old would be mostly unconcerned about his or her lack of retirement savings. But 60-year-olds in the same position likely care a lot. And that would spur them to take preventive or remedial action.
To truly understand our responses to fear, we need to go deeper into our brains and look at its functions. According to psychologists and neurologists, the frontal lobe is supposed to process analytical tasks. The older limbic system, though, is composed of mammalian and reptilian brains that control our emotions and fear. When we are faced with a threat, this older system takes control of our reactions and often drives us toward instinctive responses and we will not, in general, respond analytically or reasonably. It's the same way we would behave in the wild if we came across a bear. When people are actually facing one, they rarely remember all their learning. Our emotional mechanisms dominate our rational mind and we react according to our older and longer existing nature.
Such was the case during the 2010 crash. Those 10 minutes caused an economic shock to our limbic system, the first of its kind in terms of magnitude. While we may talk about unexpected losses, typically we don't think about the impact of sudden huge losses in a very, very short period of time because the probability is so very low.
But now that it has actually happened, we see the consequences. The investing nation is becoming much more circumspect about stocks and other volatile financial instruments. Our risk aversion as a nation has suddenly increased, which affects both trading volume and security market prices-and that eventually affects portfolio values. How younger investors are reacting is less understood.
But there is one important lesson for us all: We must find competent planners who can safely shepherd us through these times. It's also probably important to understand why older people should consider safety of principal first while younger ones focus on growing their wealth.
Scared Of Losses? You Should Be
There is a very simple way to approach investment decisions. Begin by asking yourself some basic preliminary questions. What is your investment for? To buy a house, to fund a kid's education, to fund retirement and the like? How long will these investments last? If they are for your early retirement, will they last 40 to 50 years?
Once these basic questions are answered, ask yourself this $64 million dollar question: Over your planning time horizon, how much of this money are you willing to lose? For example, if you are trying to accumulate $100,000 for a house, how much could you afford to lose without losing your bearings? What if it is a five-year plan and in year four you lose 50% of your accumulated funds? How would you feel? This is a critical question in any investment decision. But typically, you will not hear an advisor talk in such terms.
When planners talk about conservative investing, they couch the idea in terms of risk and return. In the language of these experts, these measures are often quantitative and difficult for average investors to understand. While the return on investments seems like a fairly straightforward concept (the idea of 8% or 11% historical returns, for example), risk is usually explained in terms of standard deviation, a statistical terminology difficult both to explain and understand. Hence, most investors are pretty much in the dark when it comes to making a decision about risk-even if it is their sole responsibility. They are left with no other choice but to decide whether an investment return sounds attractive. And obviously, the higher the return, the more attractive the investment will sound.
Planners may suggest that a return such as 8% to 10% is conservative while a 12% to 15% rate is aggressive, so people will go with the former, being the conservative investors they believe they are.