Investors fleeing equity funds for bond funds

The above chart illustrates net monthly investment flows for US equity mutual funds (red line on the chart) and for total bond funds (taxable plus muni) for the period from January 2007 to July 2010 (as reported by the Investment Company Institute).

For each month, some investors added funds to US equity funds and some withdrew funds -- the net (inflows minus outflows) was tallied, and if outflows were larger than inflows, the net flows that month were negative.

As the chart shows, and as the New York Times reported in a story entitled "In Striking Shift, Small Investors Flee Stock Market," outflows from US equity mutual funds have been dramatic in recent months, while net inflows to bond funds have been extraordinary since the start of 2009.

Net outflows for US equity funds through the end of July have totaled $31.1 billion, with over $12.6 billion in net outflows for July 2010 alone. Over the same period, net inflows for bond funds have totaled $182.9 billion.

This data backs up the anecdotal cases we have come across of investors pulling their money out of the stock market at or near the most recent market bottom in March 2009, thereby missing the recovery after riding most or all of the way down. (Note the point in the graph above showing heavy net outflows from equity funds in February and March of 2009, just before the turn).

This kind of behavior is exactly what leads to the dismal long-term returns highlighted by numerous Dalbar studies year after year, which we have discussed in several previous posts. While many articles (such as the Times article) focus on this as the behavior of the "small investor," it is important to note that many of these small investors (who may be quite wealthy indeed, but are referred to as "small investors" in contrast to large institutional investors) are in fact advised by professionals who bear much of the blame.

Lately, many investors are jumping out of the equity markets because they are hearing all kinds of predictions of a "double dip" return to recession, or even declarations that the recession never ended at all and the so-called recovery was nothing but a head fake.

We advise those who have fallen for such arguments to go back and read our previous posts about the danger of listening to such confident economic forecasts -- even if those forecasts come from economists, and in fact especially if they come from economists.

We would also advise them to read our post about "market-timing and train-timing," which refers back to a post we wrote entitled "Don't get off the train" -- published seven days before the market bottom on March 9.

Instead, investors should continue to focus on allocating capital to well-run, growing businesses (whether through ownership of equity or through ownership of debt securities -- we don't advocate using open-end mutual funds). Instead of fleeing in anticipation of what the market will do next (which no one can predict), they should be paying themselves first, which will result in the opportunity to buy more equities when prices fall.

The fund flows depicted above tell the sorry tale that most investors are not following these common-sense principles, and many will wind up getting seriously hurt in the process.

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