As a group, retail investors have never been praised for their investing prowess. Maybe it is because they are too inclined to follow the latest trend, or maybe it is because they lack the sophisticated tools of the seasoned professionals.
Whatever the reason, individual investors have a bad habit of selling low and buying high -- and investors who are willing to go against the grain can use these patterns to their advantage.
According to the latest statistics on mutual fund sales in the United States, retail investors fled the equity market when it turned volatile in August, when they should have been embracing the lower valuations. And now that equity markets around the world have been rebounding, retail investors are jumping back into equities.
This newfound optimism for stocks is a possible sign that the equity market may be getting a bit stretched.
"Looking forward, the challenge will be to time when sentiment and valuations have finally overheated to the point where the cyclical risks become unacceptably high," said BCA Research in a note to clients.
That point could come early next year -- and fund flows could be one of the key indicators. As 2007 grinds on, mutual fund performance figures will probably look better and better. That is because many mutual fund companies advertise their five-year annualized performances, and five years ago equity markets were just emerging from a prolonged downturn. In 2002, the S&P/TSX composite index fell an alarming 22.1%. The S&P 500 fell 12.4%.
Drop 2002 performance figures, or at least the worst part of them, and the five-year statistics start to look a lot better. At the start of this year, the trailing five-year annualized performance of the S&P/TSX composite index was 13.1%. Ditch 2002, though, and this yearly performance jumps to nearly 20%. For the S&P 500, the corresponding performance figures are 6.2% and 14.4%, respectively.
Mutual funds, which perform a lot like their underlying indexes when their returns are lumped together, will show a similar improvement. In other words, if you ignore the 2002 dip in stock prices, investing in equity mutual funds looks twice as good, a point that fund companies are bound to point out.
"Given that mutual fund investors are often attracted to these five-year statistics, we would not be surprised to see a better pick-up in U.S. fund flows in 2008 -- a potential catalyst for additional market appreciation early next year," said Tobias Levkovich, chief U.S. equity strategist at Citigroup.
Same goes for Canadian mutual fund investors, who follow similar investing patterns. But keep in mind that too much enthusiasm among retail investors can lead to problems ahead, when bullishness turns sour. When the little guy can't get enough of the stock market, it might be time to lighten your own exposure.