The concept of loss aversion is no secret anymore. Losses have a bigger impact on investor psyche than do equivalent gains.
Judging from recent fund flow data, the memory of a loss appears to be longer lasting than that of a win as well.
In the past, investors often pulled money from equity funds and bought fixed-income products during strong stock markets that followed downturns. They were too busy licking their wounds and lost out on those potential stock gains.
And sure enough, we see a strong trend today in mutual fund flows that suggests investors have begun earnestly diversifying their portfolios toward fixed-income products, in many cases away from equity funds. Over the last three years, mutual fund investors have injected $4.87 into fixed-income funds for every $1 into equity funds.
We also see a new trend emerging. Whether created by defined contribution plan defaults or by investment design, investors appear to be embracing the one-stop benefits of investing in target-date and target-risk funds.
These funds attracted some $220 billion during the three-year period ended Dec. 31, 2011, ultimately leaving the remainder of the equity funds group in net-redemption territory to the tune of about $82 billion for the same period. Meanwhile, an old staple of most U.S. investors' portfolios, domestic equity funds, have experienced a startling decline in net new purchases. Estimated net flows have shown an exodus of approximately $211.5 billion during the last three years, despite posting the second strongest three-year average annualized return (14.12%) among Lipper's four equity macro-groups for the period. They were outpaced only by Sector Equity Funds (14.82%).
Many pundits think the pendulum has swung too far. The financial crisis appears to have severely influenced investor behavior. After watching equity portfolio values decline 39.28% on average in 2008, many investors threw in the towel—and essentially completed the wealth-destroying cycle of selling low.
However, if we look at the distribution pattern of returns over the last 10 years, we see the historical pattern of three down years and seven up years still holds. While the average equity fund return for the 10-year period (+4.42%) lags the 87-year average (+8.42%), investors who stayed out of the equity markets missed some very strong returns and probably are still in the red.
Recent events show us that with a long enough investment horizon, a well-diversified portfolio, and a regular rebalancing plan, even extremes in the market can be mitigated.
Consider the 2002 and 2008 market meltdowns. Each time, the subsequent year posted strong equity returns—35.9% in 2003 and 34.6% in 2009.
While we cheer what appears to be a new trend of investors diversifying parts of their portfolio to different asset classes (fixed-income, commodities, world securities, REITs, and hedge-like funds), we believe the memories of recent losses are keeping many investors out of the equity markets. Perhaps they are following the old adage, "fool me once, shame on you; fool me twice, shame on me."
However, in this fickle market you should not procrastinate too much. If you are waiting for the perfect time to reenter the equity market, you'll probably wait until it's too late in the market cycle. Remember, often it is much more beneficial in the wealth creation process to go against the grain and do what is uncomfortable.
Over the last 87 years, the number of years of equity outperformance beat underperformance 63 to 24. So don't let a fear of loss alone drive investment decisions. Instead, stick to your asset allocation strategy with regular rebalancing. That will force you to buy low and sell high. Otherwise, you may find yourself doing the exact opposite.
Tom Roseen is a senior analyst at Lipper/Thomson Research.