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.

Instead, investors might ask: Could half their funds be wiped out in any year, including the last one? What is the likelihood that could happen? Or what is the likelihood that 25% could be wiped out in any given year? Suppose your planner shows how your $100,000 will grow to $150,000 in five years with an average return of 8% per year during that time. Under these circumstances, what is the likelihood that you could also lose half your accumulated funds in the last year and come out with a negative investment return, even though you still earned that 8% average rate over the five years?

As we know now, such possibilities not only exist but are more common than we thought. An extreme case in point is the 2008-2009 financial debacle. If your investment was maturing in 2009, the outcome would have been a lot worse.

This concern about loss is what should drive our investment decisions. Most planners are unable to explain this loss aversion to their clients because they are not adequately educated to understand the concept themselves. However, as we mentioned before, the solution is simple. Reconsider the example above of earning an average annual rate of 8% over five years. While it sounds conservative on the surface, it is actually quite aggressive. Earning 8% a year for five consecutive years (or averaging out over the five years to an 8% rate) is a very tall order. To do that, in most cases, one would actually have to be exposed to a large amount of loss risk in any given year.

Without getting into the details about standard deviation and the propensity for loss, we can use estimates (very rough ones) to view the 8% investment opportunity another way. It means understanding that, in any given year, you may not even earn a dollar. Also, be prepared, because this could happen every year. The likelihood of such an outcome is astonishingly high-about 25%. Thus, the investment decision is about whether you are willing to bet that the odds of loss are one in four every year for five years. Of course, the reverse is also true: In each of those years, you have a 75% chance to earn a positive return on your investment, and the earning rate itself could be anywhere from zero to the highest rate imaginable. Furthermore, there is a 12% chance you could lose 8% a year for five years!

In prolonged economic downturns, which are not so uncommon, such are the outcomes. Now ask yourself this question: If you were told about these odds of loss, would you still consider the 8% investment opportunity to be conservative? Hopefully not, especially when you feel unsettled about the existing economic state of affairs. Nor would you consider a 10% return to be attractive, considering yourself conservative just because you rejected a 15% return.

As we discussed earlier, this idea of loss aversion is probably the most powerful tool in the investor's bag. Once you understand the implications of loss in any investment decision, you can make a dimensional shift, offering something easily understood and applied by all investors. If most investors behaved that way, collectively we would make the investment market a much safer place.

Unfortunately for now, there are no known ways of educating all investors about this critical aspect since the tools that currently exist are all based on statistical concepts of risk and return that make little sense to most lay people.