US Stocks Rally in September, but Many Investors Missed It

At first glance, it looks like investors still don't get it when it comes to the right strategy for investing. But look a little deeper, and there's some hope on the horizon.

According to Morningstar, assets in U.S. stocks decreased for the fifth straight month, meaning that investors have pulled $65.1 billion from domestic-equity funds since April. How were those who fled the asset class rewarded? We just experienced the best September for domestic stocks since 1939, as the S&P 500 Index rose about 9 percent for the month, and the third quarter saw the index rise by more than 11 percent. The performance of the third quarter debunks another bit of "conventional wisdom" that markets follow cash flows. If they did, the market would have fallen in the third quarter.

Unfortunately, the evidence from academic studies is that individuals invest as if driving forward while looking at their rear view mirror. They buy after periods of strong performance and sell after markets have experienced steep losses. For example, after the 2008 bear market, more than $300 billion was withdrawn from equity mutual funds in 2009. Buying high and selling low isn't exactly a prescription for investment success.

One reason investors do so poorly is they don't know their investment history -- stocks are much more volatile then they believe. Thus, when the risks show up, they're unprepared and panicked selling is the result.

One of the questions I am most asked these days is: "When will things return to normal?" My answer is they're never "normal." Consider that while the S&P 500 had average annual return of 11.8 percent for the period 1926 through 2009, only six of those years saw the annual return fall between 9 percent and 14 percent. And there are almost as many years (32) with returns over 20 percent as there are years (34) between -8 percent and +20 percent. The only sure way to earn those great returns is to be there all the time.

Here is another example of the futility of market timing. A Sanford Bernstein study of the monthly returns of the S&P 500 from 1926 through 1993 showed that the 60 best months (out of 816 total months) averaged a whopping 11 percent. The remaining months averaged 1/100 of 1 percent. That means, on average, less than one month a year accounts for all the returns of the market - demonstrating that September 2010 wasn't unusual at all. Smart investors, like Warren Buffett, know that efforts to time the market are highly likely to prove unproductive because so much of the action happens in very short and unpredictable bursts, often following periods of extreme negative performance.

Others may tell you that market timing statistics such as these are hooey, but the truth remains that your best chance of capturing these returns (and thus, the returns of the market) is to remain invested at all times, as these big returns are random. Otherwise, you risk being one of the investors we just discussed: selling out of the market and missing an outstanding period.

Before we completely bash investors for following the herd mentality, it's important to note that there's a bright spot in all this data. Last month, Morningstar noted that passively managed domestic-equity funds have received inflows in 34 of the previous 36 months. Passively managed funds now hold 20 percent of domestic-equity fund assets, up from 15 percent in 2000 and 18 percent one year prior.

One of my favorite quotes seems very appropriate for this. Victor Hugo once remarked, "There is one thing stronger than all the armies of the world, and that is an idea whose time has come."

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