Despite rising risks and low potential returns, investors continue to hoard cash and pour their money into fixed income. Certainly the global economy remains troubled, but we are no longer in crisis and both U.S. and international equities look attractive even after assessing risks. With interest rates at such low levels, resulting in miniscule yields on bonds and cash, I believe investors need to take a more balanced approach to generating income and long term gains if they ever want to retire, make their money last and maintain purchasing power during their retirement.
Back in 2006 the average annual income generated by a $100,000 6-month CD was $5,240. In 2011 the average was only $419.1 Despite this fact, cash as a percentage of total household financial assets continues to be well above historical averages and much higher today than it was during times like 2006 when rates were substantially higher.1 Seems counterintuitive doesn’t it? When cash rates are high, investors don’t hold much cash but when rates at historical lows, investors are in love with cash!?!
Studying the flows of investor money into and out of mutual funds and exchange traded funds (ETFs) is a great way to gain some perspective. Market cycles exert a powerful pull on investors. For many the natural inclination when faced with uncertainty, confusion and market losses is to flee. In general, as markets rise money flows in and when the markets falter outflows follow. Regrettably many investors buy high and sell low. Since the 2008 we have seen record outflows from stocks and record inflows into bonds. As of August 2012, there has been $1,288 billion of flows into bond funds and fixed income ETFs since 2007. During the same time a total of only $209 billion has flowed into stock funds and equity ETFs. Bond fund flows exceeded equity flows by $51 billion in August 2012 alone!1
This pattern is nothing new. A study of the fund flows in domestic and international equity mutual funds and ETFs over the last several years shows a remarkable correlation with the returns of the global markets.2 The largest inflows into stock funds occur at market tops like in early 2000, 2004 and 2007.Large stock outflows occur at market bottoms like 2008. It should be no surprise that the largest quarterly outflow the last 10 years occurred during the fourth quarter of 2008 at the height of the financial crisis.
Currently we have record flows into bonds and outflows from stocks. This should be telling us that stocks will most likely outperform bonds over the next chunk of years and bonds are most likely priced for disappointing forward returns. This is particularly true giving today’s historically low interest rates. This repeating cycle of human emotion endures. Positive returns lead to excess optimism, then overconfidence, greed and mistakes (i.e. buying high). Negative returns lead to despair, disillusionment, distrust and mistakes (i.e. selling low). It is difficult to time these trends with any degree of accuracy. That is why I believe investors need to own both stocks and bonds at all times. This balanced approach has been proven to generate solid long term returns over all market conditions.
J.P. Morgan, Guide to the Markets, 4th Quarter 2012
- American Funds Insights – Managing bear behavior – Winter 2009
Damien helps individuals invest and manage risk. He is a Certified Financial Planner™ professional and a principal of Walnut Creek Wealth Management. These are the views of Damien Couture, CFP® and not intended as investment advice. Your comments are welcome. Damien can be reached at 925-280-1800 x101 or Damien@WalnutCreekWealth.com.