Investors have a short memory and notoriously bad timing. Three years ago investors were fleeing the stock market for safety. Now investors are fleeing safety for stocks. It’s the perfect storm for financial trouble.
For the week that ended Feb. 2, 2011, the net inflow to stock mutual funds was $1.7 billion. In the previous week, the net inflow was an unbelievable $5.11 billion. A chunk of the money flowing into stock funds is coming directly from bond funds, which had a net outflow of $1.1 billion for the week ending Feb. 2 and an outflow of $2.7 billion for the previous week.
The vote is in. Investors believe the stock market recovery has just begun. They are jumping on board before it is too late. This optimism is fueled by the financial media and investment professionals who confidently predict the future. "Everything seems to be in place for the stock market to rise,” Steven Goldman, a market strategist for Weeden & Co., told CNNMoney in a representative comment.
So, is it time for you to dump your bonds and hop on the bandwagon? Not so fast. Investors have an uncanny ability to buy at market highs and sell at the lows. Take a look at this data:
What did investors do during this period of rapid recovery in the stock market? They bailed. Net inflows to bond funds and out of equities peaked at $231 billion. These investors missed out on the rapid run-up in the markets. The flee to safety was fueled by expert advice, just like the current flee from safety. Joel Framson, president of Silver Oak Wealth Advisors in Los Angeles, noted in an article published in October, 2009 that his firm started using bonds as an “equity replacement” for his clients.
Instead of investing based on nothing more than the musings of financial experts, you should be following basic principles of finance that have withstood the test of time and are based on hundreds of academic studies. Determine how much of your portfolio to allocate to stocks and bonds. (You can find a good asset allocation questionnaire here.) And purchase a globally diversified portfolio of low management fee stock and bond index funds in an asset allocation appropriate for you. If you have less than five years before you will need 20 percent or more of your invested funds, you should have no exposure to stock market risk. The short term volatility of the stock market may cause you to sell at a loss.
[See The Arrogance of Trading.]
An investment strategy based on a guess about the short term direction of the market is gambling, not investing. Bobbing in and out of the markets is risky business, and a prescription for disappointing returns. The stock market may, or may not, continue its remarkable recovery. No one knows. As the late economist, Paul Samuelson, America’s first Nobel Prize winner in Economics, put it: “It’s not easy to get rich at Las Vegas, Churchill Downs, or Merrill Lynch.”
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.