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One of the most important questions mutual fund investors face is how much of their total investable assets should they now be allocating to stocks vs. how much to bonds, cash, or any other alternatives. This article will try to shed some light on this question without, however, providing a definitive answer since only investors themselves can decide on their own appropriate asset allocation based on how they view the prospects for each of these asset categories as well as what they see as the purpose of their investments.

A Shift in Investors' Stock vs. Bond Allocations

The US stock market continues to befuddle anyone desiring to get a clear sense of where the overall market might be heading. It has see-sawed back and forth of late while having shown only minimal gains over the past 5 years. All the while, a pervasive sense of gloom has eroded stock fund investors' confidence that the foreseeable future will turn out any rosier. Bond fund investors, on the other hand, have tended to see a fairly constant positive performance in recent years, although not overwhelmingly so.

Most investors have generally assumed that over the long term, stocks will nearly always perform better than bonds. Thus, they typically overweight them compared with bonds in their portfolios. (Of course, some investors are exclusively interested in the "guarantees" of income they receive from bonds; therefore, many of these investors would not likely invest much or anything in stocks regardless of the very long-term history of superior past performance.)

It has not gone unnoticed by investors that during the last decade (2000-2010), bonds have generally showed better overall performance than stocks. But many investors have stuck to the assumption that stocks would prove to be better investments. So, given stocks' recent underperformance vs. bonds, especially over the last 5 years, such die-hardedness has proven to be to these investors' detriment. (Over the past 5 years, the average stock fund has returned about 0% for those who maintained their positions, that is, buy and hold investors. Over the same 5 years, the main index for bonds, Barclays Aggregate Index (NYSEARCA:AGG), rose steadily from about 100 to over 109 while all along providing dividends. And the typical taxable intermediate-term bond fund is about 5.5% higher per year, or about a 27.5% cumulative return.)

Given such results, it should therefore come as no surprise that many investors have begun to tilt more in favor bonds, as measured by fund flows in and out of bonds vs. stocks. These investors, having seen their prior expectations shaken to the core, have gradually begun to shift their asset allocations toward a greater weighting to bonds, cash, and alternative investments and less to stocks. This process appears to have gained momentum especially over the last several years. It therefore makes sense to try to assess whether or not such a move is likely to yield better investment results than most of these investors have been receiving under their prior more stock-heavy strategy.

Will the "Real" Stock Market Please Stand Up

In spite of the poor overall returns, the past 5 years however have not been consistently bad for stock fund investors. There have been two distinct, and roughly equal in length, sub-periods of highly contrasting performance. From late 2006 to early 2009, stocks in general fell considerably, with the S&P 500 (NYSEARCA:SPY) Index dropping from a high of 1382 to a low of 673. In contrast, from March 2009, thru the end of Oct. 2011, the S&P 500 rose from that same low to the current level of around 1285 (thru 10-28).

As a result of numerous disappointments over the last 10 to 11 years (two severe bear markets, periods of extremely high volatility, and now long-lasting poor economic data, to name a just few) along with the poor 5-year performance cited above, investors have become, seemingly justifiably, lacking in confidence in future returns for the market. Thus, in recent months, investors have been less bullish than usual on the stock market's prospects and more bearish. On the other hand, the relatively smooth and positive returns in the bond market have allured a greater number of investors into thinking that that is where they should be now be targeting more and more of their investments.

But, as we've pointed out, stocks have shown two faces over the last 5 years. In fact, since the March 9, 2009, bear market low, the S&P 500 Index is up a whopping 91%, not including dividends of about 2% per year. Thus, in spite of two near bear market corrections, one during the last 6 months and one in mid-2010, the stock market has been a highly profitable place for your money over that nearly 32-month period.

You might ask yourself, which of the two stock market snapshots is the one to "believe in" when thinking about how much faith you have in the market going forward: the current 2 1/2 year one, which has been highly profitable, or the overall 5 year one that has not? After all, the overall market trend can be an important predictor of future performance, at least in my opinion. (Of course, if one is a thick or thin, die-hard, buy and hold investor, this question is moot since these investors believe in maintaining their position "no matter what.")

It might seem most reasonable, and sounder logically speaking, to assume that the longer 5-year view (not to mention the 10- year view, which also generally shows a stock market barely showing any profits) would be the one to carry more weight in forming your judgment. A 5-year trend would seem to be a more reliable and therefore "safer" way to decide how much risk to subject your hard-earned money to than a mere 2 1/2 year one.

But it seems to me that the great majority of investors who are shifting their allocations are basing their actions on the following supposition: the US economy is not at all in good shape, and neither President Obama, Congress, nor the Federal Reserve Board will be able to do much, if anything, to improve it. In fact, it is based on this assessment that Barack Obama has recently been forecast to suffer a "heavy defeat" in 2012, by the economic advisory firm IHS Global Insight. (Of course, some investors moving out of stock funds may be doing so out of necessity because they need to be sure of having cash on hand.)

If we are correct that many investors share a sense of pessimism, then fund investors are apt to continue to reduce allocations to stocks, or at least, not consider adding to their currently held stock fund positions. And while bond funds have never been investors' perennial favorites, at least some degree of positive returns certainly appear better to some than taking the risk of returns that could be considerably worse in a stagnant economy.

A Contrarian Approach

Obviously, no one can know whether a relatively high or low allocation to stocks will prove to be the better choice over the next year or two, or even longer. But from what I've already said, it appears that more and more investors will be acting cautiously with regard to their stock positions.

But time and again, the stock market usually confounds a logical analysis: Just when investors appraise the situation as particularly dire, good returns somehow appear, and vice versa. In my opinion, we are likely to be in just such a situation now.

Why are good investment returns usually illogical and contrary to expectations? Because once severe problems are recognized, as appears largely to be the case today, many of those prone to sell will have already done so. These occasions can be recognized when problems are already so severe that "worst case scenarios" are already viewed as likely. If these scenarios do in fact occur, little further selling by investors may happen because that's what people expected anyway. But if there is even a gradual amount of improvement from the dire picture, a cadre of aggressive investors who mainly invest in individual stock issues and really move the market (not fund investors) are likely to begin buying in earnest, pushing stock prices up, often at a highly rapid pace.

This is what appeared to have happened in March 2009. And we suspect it may happen again in the near future, if it hasn't already begun happening this month. In March '09, like now, conditions appeared bleak with no apparent resolutions in sight. A careful realistic analysis of various sobering issues currently seem to "logically" suggest little to give anyone confidence that either the US or the major regions of the the world (except perhaps for some emerging market countries) are on the right track, or have good prospects for resolving their numerous difficulties anytime soon.

Are we suggesting that ordinary fund investors now make big, bold bets in an attempt to reap big rewards? Perhaps only if you are a highly aggressive investor. The wisest strategy would appear to be investing across the investment spectrum in stock, bond, and alternative funds for the foreseeable future, with at least some overweight for stocks for moderate and aggressive investors.

Source: Stocks Vs. Alternatives: The Fund Investor's Asset Allocation Dilemma