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Although there may be some Main Street investors who don't make a habit of getting into and out of the market at exactly the wrong times, as a whole, the general populace has a pretty bad track record of timing the market. Most investors tend to pile into overvalued asset classes that have experienced run-ups and hot returns just as readily as they flee the scene after a large market decline or downturn. While this behavior certainly seems rational, it is in direct opposition to what you need to do to be successful over the long run.
Against the tide
Unfortunately, recent mutual fund flow data from industry trade group ICI show that investors are still chasing returns and moving money into asset classes long after they should have changed direction. For the week ending Jan. 26, investors put $3.2 billion into domestic stock funds, $1.9 billion into foreign equity funds, and another $1.9 billion into hybrid funds that invest in both stocks and bonds. Yet unbelievably, the sector that saw the largest inflow was once again taxable bonds, with $3.5 billion in net inflows for that week alone. True, municipal bonds suffered outflows of $2.7 billion, but investors apparently have not given up on bonds just yet.
I find it a bit disturbing that investors are continuing to flood the bond market with money. Given where bonds are in their market cycle, and with rising inflation and interest rates right down the road, bonds don't have much more room to run. Warnings about a possible bond bubble abound in the media today, but investors apparently don't care or were so traumatized by the last bear market that they still crave the safety of bonds, even if returns are beyond weak. I don't think investors should avoid bonds altogether, but people stuffing those billions of dollars into bonds may be unpleasantly surprised down the road.
Late to the game
Looking at inflows on the equity fund side, I'm glad to see that investors are no longer running away from domestic stocks. However, they are adding to their equity positions much too late in the game. Consider that the market reached its trough in March 2009 and has subsequently rebounded sharply, with the Dow up over 85% since that time. But it's really only been in the past two or three months that investors have stopped pulling money from their stock funds and started getting back into the game. That's almost two years after the market bottom. That means they've missed the greatest part of the market rally by following the crowd out the door when times got tough.
Research from Prudential Financial looks at the average returns of the S&P 500 Index during the last nine bear markets (not counting the most recent such event). It found that while the S&P declined an average of 32% during a bear market, the average return during the first year of the recovery was 36%. The second year average return was only 12%, and the third year of the recovery only saw a 1% return. It's pretty clear from history that most of the big returns during a rebound come immediately following the bear market trough, not years afterward when investors finally decide to get back into the market. That's the price of chasing returns and moving into and out of asset classes at the wrong time.
Back in business
If you're just now getting back into the stock market, realize that you've already missed out on all the low-hanging fruit out there. If you're expecting the stock market to return another 85% in the next two years, you're going to be sadly disappointed. However, given current valuations, stocks will almost certainly offer greater return opportunities in the near future than bonds, so don't use that as an excuse to avoid the equity market.
If you've been paying attention to investing news, you know that dividend investing is pretty hot right now. I agree that there's a lot of opportunity in this segment of the market, so this is a good area to dip your toes back into if you've been skittish about stocks. If you're an ETF investor, the Vanguard Dividend Appreciation ETF (NYSE: VIG ) is a good bet for investing in a broad collection of dividend payers, including names like Home Depot (NYSE: HD ) and Chevron (NYSE: CVX ) , both of which sport dividend yields in excess of 2.5%.
On the actively managed side, T. Rowe Price Equity-Income (PRFDX) has a long, solid track record of dividend investing. Longtime manager Brian Rogers is on the lookout for firms with strong earnings and free cash flow, in addition to a decent dividend payout. Low-P/E financials such as JPMorgan Chase (NYSE: JPM ) , American Express (NYSE: AXP ) , and Bank of America (NYSE: BAC ) are favorites in the portfolio here. The fund has beaten more than three-quarters of all large-cap value funds in the past decade and a half, so you're not going to go wrong with a solid strategy like this.
Likewise, if you've been stuffing money into the bond market in recent years out of fear of another market drop, you need to re-examine your priorities. If you are close to or in retirement, you will certainly need a hefty allocation to bonds. However, if you've still got a few decades left before you hit your golden years and a large chunk of your assets is in cash or bonds, put that money to work! Bonds aren't going to give your portfolio the growth it needs to reach your long-term retirement goals, so you're going to need to invest in the stock market, no matter how scary that may seem.
It's not easy to go against the grain and invest where others fear to tread, but that's the key to earning the highest returns. That means you've got to resist the temptation of chasing returns and selling when things get rough. Folks who are thinking about fleeing the muni bond market now might do well to keep this information in mind. The best buying opportunities occur when fear and greed are highest, so view these situations as a chance to profit, not as an obstacle to overcome.