Has the "Dumb Money" Finally Gotten Smart?

Investors like to buy low and sell high. But while some mutual fund shareholders were lucky enough to sell at the peak last summer, many more have been willing to sell lower, getting out of stocks only after suffering heavy losses.

The tendency of many fund investors to make the wrong move at the wrong time has earned them the title of "dumb money." Want to avoid that label? By examining what the crowd is doing, you can profit by avoiding its mistakes.

To track where average investors are putting their money, the Investment Company Institute tracks mutual fund flows on a monthly basis. Over the past 12 months, the results are striking:

Source: ICI. Figures run from June 2007 to May 2008.

Saving your powder
The most obvious trend is the amount of cash that investors are holding in money market funds. In the past year, the Federal Reserve has cut rates from 5.25% all the way down to 2%, bringing rates on the three-month Treasury bills that many money market funds hold to below 1.5%.

Clearly, money-market fund investors aren't getting paid well to keep their money locked in ultra-safe short-term paper. But so far, those who've held high cash balances probably feel like they've hit the jackpot. They've missed out on at least part of the 20% drop in the major stock indexes from last year's highs. Rather than trying to catch falling knives in financials like Washington Mutual (NYSE:WM) and Lehman Brothers (NYSE:LEH), they may feel comfortable in following Warren Buffett's first rule of investing: Never lose money.

Behind the curve?
When you look more closely at the monthly fund flow figures, however, you see that most investors are merely reacting to market moves, rather than taking proactive steps to safeguard their portfolios. The largest outflows from U.S. stock funds tended to occur when the market was doing its worst. For instance, during January, investors took out a whopping $35.6 billion from U.S. stock funds as the S&P dropped more than 6%, concluding a nine-month string of outflows.

Similarly, only after markets showed temporary signs of recovery in April and May did fund shareholders step up to the plate, adding more than $13.6 billion to domestic stock funds. Although figures for June aren't out yet, I'd anticipate seeing new outflows, as more panicking fund shareholders finally reach their breaking points and capitulate by selling shares.

Moving abroad
More surprising, however, is the confidence investors have shown in foreign stocks. Even as markets abroad have suffered steep declines of their own, fund investors haven't been deterred in their continued buying. Only in two months -- January and March -- did foreign funds see net outflows.

There are a number of possible explanations for investors preferring foreign funds. While Asian markets like China and India have been hit hard so far this year, several Latin American markets, including Brazil and Mexico, are still up slightly in 2008.

Perhaps more importantly, foreign stocks in hot sectors like energy and mining are among the most well-known among U.S. investors. Oil stock Petrobras (NYSE:PBR) and miners BHP Billiton (NYSE:BHP) and Vale (NYSE:RIO) have held up reasonably well, even as most stocks have fallen sharply.

Also, fund shareholders may believe that foreign stocks are actually safer than U.S. companies. Japanese banks, for instance, avoided much of the subprime crisis, leaving them better poised to take advantage of global opportunities than American counterparts Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM). As the U.S. economy looks more dicey, investors hope that the rest of the world can decouple itself from the U.S. if we enter a deep recession.

Stay smart
For most people, these patterns of fund flows don't make any sense. Ideally, you should aim for a steady inflow of money into mutual funds during your career, and then when you need that money after you retire, you'll have steady outflows from those funds. If anything, you should increase your investments when stocks drop, rather than moving money out of stock funds when they're down.

That's hard to do when shares are falling every day. But if you can go against the crowd and stick with regular contributions to mutual funds, you'll improve your results over the long haul.

To learn more about mutual fund investing, read about:

• Why you shouldn't buy some top-performing funds.
• Want to lose money? Here's a shortcut.
• How to take advantage of the next market bottom.