People don't buy umbrellas until it rains. They don't buy overcoats until the thermometer plunges below freezing. And many don't buy stocks until the market is up. Way up. We've seen that dramatically this year, as retail investors emerged from their bond-market cocoons and jumped back into stocks.
From 2007 through 2012, they pulled $600 billion from U.S. equity mutual funds while putting twice that amount into bond funds, according to the Investment Company Institute. But in January, investors started pouring money back into U.S. stock funds -- some $19 billion, their biggest such contribution in more than six years, according to ICI data. Since then, it's tapered off a bit, although flows into foreign equity mutual funds have remained strong.
Meanwhile, retail brokerage firms like Fidelity, Schwab, and TD Ameritrade reported substantial increases in trading volume over 2012. Anecdotal evidence of a sentiment shift is also plentiful. This is from USA Today:
Efren Hernandez, 49, a government worker from Los Angeles, got back in the stock market this month after selling most of his stocks in 2007 and 2008...
[Joanne] Mechling, 47, a married market researcher with no kids from Portland, Ore., admits that the fear of missing out on gains has given her a new sense of urgency to get invested. With the market near a new high, ‘it's definitely safe to invest now,’ she says...
Investors appear to have gotten back into stocks again for three reasons: equity markets' huge rallies to all-time highs, the decline in volatility (as measured by the VIX) over the past year, and the resolution of that great non-issue the fiscal cliff, which created a noisy but ultimately meaningless brouhaha in the financial media late in 2012. As The New York Times reported:
Jim Cole, a 52-year-old employee at the Bank of the West in San Francisco, had most of the money in his individual retirement account in cash at the end of 2012 as he awaited a bad outcome to the fiscal negotiations in Washington. Since Congress reached its agreement, he has put almost all of that money to work in stocks.
'There doesn’t seem to be this swirl of impending doom hanging over the U.S. economy or the world economy...,' Cole told The Times.
I don't want to throw cold water on these good people, who are doing their best for themselves and their families. But really, this is exactly the wrong way to invest. Investors who dump stocks amid fear and turmoil and then jump back in when their fellow investors are showing signs of complacency -- well, what can you say? This kind of backward market timing has caused mutual fund holders -- a good proxy for individual investors -- to underperform pitifully.
A study by DALBAR tracking performance of equity mutual fund investors in the 20 years ending December 2011 -- a period encompassing bull and bear markets alike -- showed their compound returns trailed that of the S&P 500 by more than four percentage points a year, precisely because of dreadful market timing. Just keeping their money in a no-brainer index fund or ETF and ignoring it would have been much more profitable.
This is where psychology is not investors' best friend. Most of us are buffeted (no pun intended) by conflicting emotions of fear, greed, hubris, and regret that prompts us to do exactly the wrong thing at the wrong time. Researchers in behavioral finance believe that people would much rather avoid a loss than to enjoy a gain. Many of us -- men in particular -- are overconfident in our investing ability. It's the Lake Wobegon syndrome run amok.
Investors kick themselves regularly for errors of omission -- not buying Apple (NASDAQ:AAPL) when it first came out with the iPhone, or not selling Apple when it hit $700, or maybe not being in stocks before the S&P soared 120% and the Dow Jones Industrial Average hit all-time highs. "Now what’s bothering you is that you're going to be exposed as an idiot," said Meir Statman, a pioneer in behavioral finance and professor at Santa Clara University. Regret is linked to what Statman calls "hindsight error." "Hindsight error misleads us into thinking that what is clear in hindsight was equally clear in foresight," he wrote in his book, What Investors Really Want.
And Bruno Solnik, who teaches at HKUST Business School in Hong Kong, pointed out that "regret is experienced relative to the best outcome of alternative choices that could have been made" -- like, say, investing in stocks in March 2009. Coulda, woulda, shoulda.
That's why, after four years of a bull market, I'd be pretty wary of throwing my money at stocks to "make up for lost ground." And I'm skeptical these people with a newfound affinity for stocks will really stay the course when times get rough again, as they surely will. That's why Statman suggests easing back in slowly -- over a period of months. "Dollar-cost averaging is the remedy for regret," he said.
And I'd recommend if you're going to get in now, don't put more than 25% to 30% of your money in equities. Wait for the next bear market to add more. But if you're not in it for the long haul, just don't bother. In the stock market, patience is the name of the game.