Last Updated Feb 28, 2011 9:14 PM EST
Recent History of fund flows
Over the last few years, investor behavior trended as a mirror image to the peaks and valleys of the market:
- In 2007, the last year of the raging bull, investors poured $91 billion into stock mutual funds, just in time to get slaughtered.
- When markets plunged in 2008 and 2009, investors scrambled to pull out of stock mutual funds to the tune of $243 billion, when stocks were on sale as much as 55 percent off.
- Now that the US stock market is up 112 percent, investors are again entering the stock market.
While it is completely irrational to buy stocks after an increase and sell them at a discount, it's also predictable. Both individuals and top tier financial advisors showed this irrational behavior. Many studies have confirmed that the poor timing of investors resulted in dollar weighted returns badly lagging the returns of the funds themselves.
Dan Ariely, author of Predictably Irrational, says "Following the herd is one of the things we do best, is where we get our ideas and impulses -- and in many cases it is a disastrous instinct."
Is it dumb money entering the stock market again? To be frank, my take is yes. Whenever someone is selling stock, someone else is buying it. Perhaps the plunge of 2008 and 2009 was the largest wealth transfer ever between fair weather investors and those that really understood investing.
Investors entering the stock market lately should be aware of a couple of things:
- They are likely buying stocks from the same investors they sold them to at huge discounts only a couple of years earlier.
- The best predictor of their behavior over the next plunge is their behavior over the last plunge. If they sold in 2008 and 2009, they will sell in the next plunge as well.
I've come to see fund flows as a predictive sign of future market performance. It's a counter indicator, of course. The more money that flows into the stock market, the worse it may do over the next couple of years. When funds flow out, get ready for a big rally, such as what began in March 2009.
While I do think that fund flows offer predictive value, it doesn't work every year. Market rallies can last several years such as the 2003 - 2007 bull. The fact that the 2008-2009 bear was short doesn't mean the next bear will be that short.
The instability of our risk tolerance is the wild card in every investor's deck. Inevitably, the pain of a dollar lost ends up being two-fold the pleasure felt from a dollar gained. And for that reason, investors are far more likely to panic. Accept that there will likely be several bear markets in your lifetime, and that how you handle the bears will define your success. Now is the time to be selling stocks as part of a rebalancing strategy.
Picking your asset allocation is important but not as important as sticking to it. Warren Buffett is right: "Be fearful when others are greedy and greedy when others are fearful." When the dumb money train is pulling away from the station, be sure you're not on board.
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