The Nasdaq Composite Index reclaimed 5,000 for the first time since 2000, stirring investor’s emotions.  Some investors are in high spirits.  They feel good about the money being made from the Naz’s strong momentum and the promise of still higher prices to come.  Many other investors feel disheartened, however, because they haven’t been in the market enjoying this wonderful bull advance.

These sidelined investors are now kicking themselves for missing out on one of the longest bull markets in history.  (It will turn six years old on March 9.)  Many on the sideliners were badly shaken by the 2008 bear market.  A large number swore off stocks, shifting their assets to money market funds and other “safe” investment vehicles.  Afraid of taking any more significant losses, they have kept themselves out of this strong bull market believing that every pullback was the start of a severe downdraft.  Contrary to their beliefs, every pullback since the lows of early 2009 has been a buying opportunity leading to new highs.

Fearing Losses Sidelines Investors

Loss aversion—the strong psychological tendency in investors to avoid losses—explains this behavior.  Stung by harsh losses in the last bear cycle, it seems natural to want to dodge them now.  And, it is a natural response.  But doing what’s natural and making money investing are not always compatible.  It’s one of the hard things to learn about investing.  We often have to go against our natural inclinations, and that can be uncomfortable.

Scientists believe our strong tendency to avoid loss is hard-wired into our genes.  Going around losing things of value did not support the survival of the species, so Nature made losses painful.  We know from decades of research that we experience the pain of loss much more sharply than we experience the pleasure of gain.  Researches have even been able to quantify the ratio of magnitude of loss to gain at about 2:1.  This means, for example, that when we have a winning investment that produces a profit of, say, $10,000, we feel pretty good.  If, however, we have a loss of $10,000, psychologically it will feel like it cost us $20,000.  Daniel Kahneman, the Nobel laureate, and Amos Tversky conducted pioneering research in loss aversion.  Daniel Kahneman sums it this way, “Losses loom larger than gains.”

Because losses do loom larger than gains, when an investor experiences considerable drawdowns as many did in 2008, good investment sense can become distorted.  This is what has happened for many investors.  Because of their fears, they’ve stayed out of the market and have missed the extraordinary opportunities of the past six years.

The Antidote

The antidote is two-fold: developing expertise through experience and practicing mindfulness.

Being able to make good investment decisions doesn’t come from talent, IQ, or one’s background.  Many people believe that savvy investors have some sort of special innate sense about the markets or an exceptional intuitive feel on how to invest.  That’s just not true.  Psychologists have studied expertise and what makes great performers great for over forty years.  Regardless whether you are a chess master, concert pianist, investor or competitive dart-thrower, it all boils down to hard work and lots of practice.  The expertise you develop will help you identify those points in the market ripe for an advance.

Mindfulness

Even with good experience and lots of practice, investors will still shy away from the market as a consequence of loss aversion.  This is where mindfulness comes in.  Mindfulness is a mental skill that helps investors step back from their thoughts and fears of loss.  We normally don’t question what the mind is telling us, especially when our thoughts are toned with a strong emotion such as fear.  But to be an adroit investor, one has to be able to take what the mind tells us with a grain of salt.  Think about it this way: If the minds of all the sidelined investors were right, they wouldn’t be kicking themselves now as this wonderful bull market is about to turn six years old.

Stop Fusing, Start Defusing

Believing what the mind tells us uncritically is what psychologists call fusion.  Like two pieces of hot plastic melding together, when we are fused with our thoughts and feelings, we see and act in accordance with what the mind has constructed, not reality.  Those investors who haven’t participated in the market these past six years have been fused to their fearful thoughts and feelings, unable to see the market as it really is.

Mindfulness helps the investor defuse from their thoughts and feelings, and this is a vital mental skill for investors to develop.  The practice of mindfulness—and, like any worthwhile skill, it does take practice—trains us to see thoughts and feelings for exactly what they are – temporary internal events that come and go pretty much on their own.  It’s as if our thoughts and feelings are clouds in the open sky.  Sometimes they are clear weather clouds passing overhead; at other times they bring about fierce, stormy weather.  But they always pass.  And, they never harm or change the sky.  No matter how furious and volatile the clouds, the sky remains the same.  Mindfulness will help the investor see themselves in the role of the sky and not be blown about by their erratic and errant thoughts.

Mindfulness is Potent: It Changes the Brain

Research has shown that certain areas of the brain become activated when under the influence of loss aversion.  Research has also shown that mindfulness constructively alters the physical structure of the brain in these same areas.  Known as brain plasticity, mindfulness can help make us less susceptible to loss aversion and enable us to think clearer about the market.  When we are mindful, we can remain true to our investment goals and seize the opportunities the market offers us, rather than be sidelined by our thoughts and feelings and miss the tremendous opportunities the market has to offer.

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