Fear keeps investors from gains

By Jon Markman

A year ago this week, investors stood on the edge of disaster, blithely unaware of the danger. The collapse of Lehman Brothers (LEHMQ, news, msgs) and the near destruction of the global banking system lay just ahead, and in the next seven months U.S. stocks would lose 45% as emerging-market stocks crashed 70%.

The unexpected destruction of up to $14 trillion in wealth worldwide was thus seared into the psyches of investors, most likely forever, due as much to the surprise as to the severity of the event. It had the effect of a trauma, much like a car accident or a street assault, psychologists say, and as a result it will have an effect on the way most investors perceive change in securities markets for the rest of their lives.

This is why the markets' recovery over the past five months seems so empty to most investors, amateurs and professionals alike. It's been like receiving a greeting card in the mail with a happy scene on the outside but no message on the inside. People can see the U.S. market is up 10% from the start of the year and 30% from the March lows, but it appears to have little relevance to their own sense of self-worth or portfolio value. It's more maddening and confusing than it is exciting.

Pining for Dow 14,000

Brett Steenbarger, a clinical psychologist who helps professional traders overcome mental blocks to their performance, says this is happening because last fall and winter swept away investors' sense of safety as much as it swept away their money.

Long-held beliefs in such investing precepts as the value of the buy-and-hold philosophy and diversification were thrown in the gutter and trampled. You don't overcome the collapse of a belief system in just five months, Steenbarger says. It will take years before people are able to reconnect with their portfolios and homes in the way they did in the late 1990s or mid-2000s, and until then they will not trust rallies in the market or the appearances of strength in the economy.

And yet they must, or they risk falling even further behind in their long-term obligations. Yes, this means you.

Tough, huh? Yet it's all in your mind. A key finding of behavioral scientists is that while the media and investment companies may talk about the changes in stock values from a low or from the start of a new year, people actually anchor their thoughts about a stock to a prior peak. So while financial news broadcasts may report that the market is up 10% this year, most people more strongly perceive the market as being down 30% from the highs of October 2007. As a result, the pain of 22 months of big losses still far outweighs the excitement of eight months of meager gains.

You must not fall into this trap, as I explained in columns May 1 and July 31.

It's hard, I know. Steenbarger says that trading volumes have been low since the rally began in March because most people -- again, amateurs and pros alike -- were so traumatized that they cannot bear the thought of being wrong again. They would rather be left out of the gains than expose themselves to the potential for further losses, just as people who have painfully exited long-term personal relationships cannot return to dating for months or years for fear of being wounded again.

Afraid of being left behind

So why has the market risen at all? Funny you should ask. It's because -- and don't laugh here because it's the truth -- a new bull cycle really has begun. And professionals, most of whom were losers last year, absolutely cannot remain on the outside of a bull market. So they have been piling back into stocks at every dip, kicking and screaming, no matter how much they fear that they will be wrong again.

Steenbarger says professional investors feel incredible pressure to perform this year after failing last year and have thus been selling heavily on advances as much as they are buying on dips.

"Managers who used to perceive of themselves as investors now see themselves as traders," the psychologist says. "They know that they cannot afford not to participate, but they are so nervous that they are also taking profits quickly. That's not a style most of them are comfortable with, so it has made them doubly anxious and unhappy, which is only adding to the choppiness of the uptrend."

Continued: New bull cycle is not a mirage

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