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 Four
simple words: "Buy low. Sell high." We all understand
the principal. It sounds easy enough to do. But are investors, as a whole,
actually any good at following this seemingly simple prescription for investment
success? Unfortunately, the short answer is no. But let's not just
take my word for it; let us dive-in and examine some data to confirm whether
this statement about investors' ability (or lack thereof) to buy
low and sell high holds any merit.
One way to measure investors' ability to time the market is to track
cash flows in and out of mutual funds. We can estimate the net cash flows
into a fund by comparing its assets at the beginning and end of a given
period while taking into account its performance over that same time.
For example, say in January a fund had $100 million in assets. Then in
June the fund has $110 million in assets. Additionally, over that 6-month
period the fund returned 7%. This would suggest that $7 million dollars
in the growth in assets was due to market appreciation of the fund's
holdings. The remaining $3 million in asset growth came from cash flows
into the fund.
By then taking the sum of all of the individual fund net cash flows in
an asset class (such as all U.S. stock funds), we can derive an aggregate
net cash flow into (or out of) an asset class.
Below is a graph looking at net cash flow into domestic equity mutual
funds over the past decade. (A three-month average is used because the
month-to-month data can be volatile and I am looking for the trend in flows.)
In addition to the net cash flow line is the price of the S&P 500.
To highlight a few key points in this graph: In late-1999 and early-2000,
just as the market was reaching a top, investors were pouring cash into
domestic equity funds. Then in 2002, as the market was reaching a bottom,
investors yanked billions of dollars from domestic equity funds.
Unfortunately, investors as a group bought high and sold low.
As it turns out, a decent indicator of cash flows is market performance
over the prior 12 months. The below graph depicts the same domestic net
cash flow line, but this time, looks at rolling returns over the prior
12 months. In general, when returns over the prior 12 months were up or
trending up, net cash flows were positive. When returns were down or trending
down, net cash flows decreased.
Why do cash flows tend to follow performance? Part of the answer is that
investors are not rational, emotionless robots. We are all subject to the
human emotions of fear and greed. As demonstrated by the cash flow numbers
above, fear is the pervasive emotion in the market today. If we look at
September and October data the picture is even worse: "In the first
six days of October (through Monday [Oct. 6])," reported the New
York Times, "investors pulled $19 billion out of mutual funds that
invest in United States stocks, matching the outflows for the entire month
of September."1
While we did not see the same exuberant buying of stocks at the end of
2007 that we saw in 2000, investors may be at risk of making the same mistake
of selling low that they made back in 2002.
At Kobren Insight Management we try to bring a more disciplined process
to investing. In times of uncertainty (and these certainly are times of
uncertainty!) when you may be feeling fearful, we encourage investors to
stick to their long-term financial plans. We believe maintaining balanced
diversified portfolio is the best way for many investors to reach their
long-term goals. Maintaining balanced diversified portfolios help us to
remove the emotion from investing and resist the temptation to chase performance.
In fact, by regularly rebalancing a diversified portfolio you are likely
to be adding to those areas of the market that are out of favor and being
dismissed by other investors. This by definition puts investors on the
path of being fearful when others are greedy and greedy when others are
fearful.
-- Jeff DeMaso, Research Analyst
1Lieber,
Ron. "Switching to Cash May Feel Safe, But Risks Remain." New
York Times. 10/9/2008.
Cash Flow Data comes from Morningstar Direct through 8/31/08
S&P 500 Prices came from Schiller http://www.econ.yale.edu/~shiller/data.htm
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