Perpetually Out of Step

There is increasing evidence of big flows of money into equities and leaving bonds.  This is being seen at all levels in the market, including among institutional investors such as pension plans.  The Wall Street Journal just published an article discussing this shift called Are Mom and Pop Heading for Wall Street?   Mutual fund flows suggest that investors are finally returning to equities, after selling in droves over the past several years.  This article summarizes the issue:

From April 2009 through now, mutual-fund investors sold a quarter trillion dollars in stock funds, according to recent data from the Investment Company Institute.

Ironically, that selloff coincided with a period of stellar performance in stocks—when the Dow Jones Industrial Average jumped more than 60%.

Ouch.  Mutual fund investors have been busily pulling money out of equities even as the market has risen 60%.  And now investors are returning to the equity market and buying shares at a hefty premium to what they could have purchased them for if they had invested consistently over the last several years.

It is exceedingly hard to achieve decent returns in equities if you miss a 60% rally.  This is, of course, why individual investors have so badly under-performed the long-term returns provided by the equity markets.  Over the twenty-year period through 2011, the S&P 500 has averaged 7.8% per year but the average equity mutual fund investor has averaged a return of 3.5%.  While some of this under-performance is due to the mutual fund fees and fund management, a range of analysis suggests that bad timing by individual investors probably reduce long-term returns by as much as 3% per year.

The problem is simply that our emotions drive us to make absolutely the wrong decisions.  When the economy is doing well and the market is rising, we become more bullish.  We are more enthusiastic about buying when we see that prices have risen substantially over the past year.  Conversely, we become more bearish when prices have fallen.  In other words, investors tend to be more enthusiastic about buying when equities are expensive and vice versa.  The American Association of Individual Investors (AAII), among others, has documented that investor sentiment is an excellent contrarian indicator.  In other words, investor sentiment consistently tends to be bullish when it should be risk-averse and risk-averse when it should be bullish.

To be clear, I am not predicting that the market is about to decline on the basis of the fact that individual investors are finally putting money back into stocks after shunning this asset class for several years.  The positive sentiment can carry the day for quite some time and there are a range of demographic factors that are also important here.  With bond yields at record lows, people living on investment income are being forced to seek yield in higher risk asset classes and equities currently provide more attractive yields than many types of bonds.  In addition, as the Boomers are reaching retirement en masse, there is a growing population of income investors.  Even considering these factors, I cringe when I read that investors who have stayed out of equities during the rally of the last several years are now shifting back into equities.

The tough question, of course, is what investors who have sat on the sidelines for the rally of the past three years should do.  If you have decided that you don’t want to try to time the market, the most prudent thing to do is probably to gradually rebalance your portfolio with an increasing exposure to riskier asset classes.  There are also some ‘transitional’ asset classes that have some of the properties of stocks and some of the properties of bonds.  An allocation into these asset classes provides exposure to equity risk and potential for gains, while retaining some of the downside protection of bonds.  The key asset classes here are preferred shares (PFF is an example of a preferred share fund) and high-yield bonds (perhaps with funds such as HYG or JNK).  Another asset class that may make sense for this purpose is convertible bonds (an example would be CWB, VCVSX, FCVSX, and CNSDX).

The best lesson overall, however, is simply how challenging it is to time the market.  You need to be right when you buy, when you sell, and when you subsequently re-enter the market.  A steady and consistent asset allocation—as unpopular as that seems to be—makes a great deal of sense.  For investors who still want to ‘time’ their exposure to different asset classes, the best approach is to invest on the basis of fundamentals and to maintain strict rules with regard to when to increase and decrease allocations.  The most successful fundamental variables have historically been dividend yield, bond yield, and price-to-earnings ratio.  An asset allocation strategy based on fundamentals can under-perform for quite a long time, however, and there is no assurance that it will work in all circumstances.  Buying bonds at low yields has historically been a poor strategy, but the Fed intervention with Quantitative Easing (QE) has allowed bonds to continue to deliver stellar returns for years, even in the face of low yields.  This type of ‘anomaly’ cannot persist indefinitely but it can last a long time.

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