Mind Games: Play them on yourself to become a more resilient investor

If you're invested in the stock market -- be it with an individual portfolio, through an IRA, through a robot-advisor, or through a 401k -- you should know that markets will decline, economies will suffer, and your portfolio value will decrease. You can try to create a situation for yourself where you won't be exposed to the volatility of the markets, but the only real way to do this is to not be invested in equities at all - by entering the markets you're implicitly accepting a certain amount of short-term volatility that could cause you to see your portfolio drop by quite a bit. It's how you handle this drop that determines your resiliency as an investor and, in the long-run, that determines whether or not you're a successful investor. 

Recessions Will Occur and Markets Will Decline

First, it's key that you understand that market will decline - you can't hide from this unless you're not invested in equities. If you only hold cash or fixed income securities (eg. bonds), you can safely ignore market prices on equities. In the case of cash, you don't care about the market either way. In the case of bonds -- although bonds can of course rise and fall in value based on credit worthiness and interest rates -you generally are more concerned with the ability of the borrower (eg. sovereign government, municipality, or firm) to pay as the agreed-upon schedule. If you hold stocks, however, you are exposed to two key factors:

• macroeconomic changes - changes to the firm's business, management, industry, economic moat, etc.; can be considered as unsystematic (diversifiable) risk
• macroeconomic changes - recessions, political changes, political unrest, animal spirits, depressions, crises, etc.; can be considered as systematic (undiversifiable) risk
• According to traditional financial theory, you can diversify way the idiosyncratic risks described above by the possible microeconomic changes, but you can't diversify away from the systematic risk (eg. market risk) that arises from the possible macroeconomic changes above. In simple terms, if you're in the markets you can remove exposure to the microeconomic changes above by properly diversifying, but you can't get away from beings exposed to the macroeconomic changes no matter how much you diversify - regardless of what you do, if you're invested in equities, you're exposed to the possible above macroeconomic changes. 

Exiting the Stock Market at a Macroeconomic Downturn is One of the Greatest Mistakes an Investor Can Make

Imagine you own your house outright in 2007 and then in 2008 through 2010 the housing market starts to decline as it did in the US. Would you sell your paid-for house after seeing a drop in real estate prices of 30% or more? Clearly, that would be idiotic if you didn't need the money for something specific. Why, then, do so many investors feel so inclined to sell their stocks after a market drop? Just as with a paid-for house, you own your stocks outright unless you bought them on margin (highly unlikely for most retail investors). 

Adding a mortgage on the house makes the situation riskier and it is, therefore, more understandable that you might need to sell your house in an economic downturn (eg. income loss). However, people are still far more inclined to sell losing stock positions in a macroeconomic downturn than they are to sell their mortgaged house. This doesn't make any rational sense and it represents a fundamental flaw in the way most people approach their portfolios. 

Now, if something fundamental changes - meaning one of the following:

• your risk tolerance changes
• your investing time frame changes
• the fundamentals of the stock (eg. management, type of business, economic moat, etc.) changes

THEN you can be justified in existing a position. In this case, you'll be exiting, not because of a macroeconomic decline, but because of a macroeconomic change to your world of the stock you're holding. 

In other circumstances, however, existing a previously good position is just foolish and will lead you to underperform the market over the long term. Additionally, you'll be effectively shooting yourself in the foot - you will be purposely selling off at the worst possible time instead of holding out a bit for a far better market scenario where a more fair value can be obtained for your investing. ​

Play Mind Games With Yourself to Prepare for the Inevitable Market Decline

One of the greatest ways to prepare for the inevitable market collapse (if you still think that this won't happen you need to go back and diligently study investing history before you proceed any further into the markets) is not use the same tactic elite athletes use to prepare themselves for competition - mental visualizations of game day with a focus on the desired outcome and the challenges that will likely be faced. 

Elite athletes focus on the win, but they also visualize and understand the pain and the suffering that game day will likely entail. Instead of being optimistically naive, they in advance fully understand how difficult game day will be, they accept that difficulty fully, and they commit to persevering in spite of it. 

Applying that same theory to your investing life you might want to visualise the goals you want to achieve (eg. the return you want to obtain over time or the number you want to hit in your portfolio) but you also will want to sit down and imagine how a 10% market drop will feel, how a 25% market drop will feel, and how a 50% market drop will feel. 

Typically a 10% market decline will occur once every couple of years, a 25% market decline will occur once every decade or two, and a 50% market decline will occur up to a few times in your investing life. Failing to prepare for this almost inevitable circumstance could cause you to sell at a 50% market drop - clearly a very unpleasant outcome if waiting just a few years would allow you to recover all of your gains as has been shown via a study of US stock market history. 

When you're playing these mind games with yourself it's key to really visualize the scenario and get that negative feeling in your gut you would get on the morning fo the crash. You will likely not have as intense emotions as you would actually staring at your dropped portfolio, but you should definitely feel that nasty feeling in your stomach. If no feeling accompanies this exercise you're doing it wrong and you should continue doing it over time until you really get that unpleasant gut feeling. 

Once you have that gut feeling, let it wash over you and don't try to make it go away as humans tend to do with all emotions. Let the feelings stay with you and explore it a bit. See what that feeling is telling you to do. Realize how your emotions are ruling over you instead of anything rational - this is dangerous because investing is very unnatural to human beings and only rationality will help you do well. Tell yourself

• that this is just a market crash and that if nothing fundamental has changed nothing needs to be done
• that this is totally predictable and normal - markets decline and drop and it's happened before and will definitely happen again once markets recover and rise again according to the business cycle
• that you're invested in the markets because you have a long-term time horizon and that given that time horizon markets have plenty of time to recover and rise beyond previous peaks according to investment history that this is actually a great time to buy more stocks in great firms at cheap levels - this is like a sale in the stock market and this is the time to buy

It's important to not underestimate the power of such mental exercises. It's easy to dismiss this and argues that imagining things during a bull market won't help you when things really go bad and you actually are sitting in front of your broker's website looking at a number that is 50% less than it was yesterday. Of course, the two things aren't the same, but the power of visualizing is far greater than meets the eye at first. A lot of mental resilience to making foolish moves can be built up using the exercise above and be doing it once a quarter will over time create a  healthy mental discipline against acting like a crazy person when things really go bad int he stock market. ​