Last this week, I was reading Individual Investors Help Drive Stock Surge in The Wall Street Journal. The opening sentence, “Small investors are jumping back into the stock market after abandoning it during the financial crisis” got me thinking about why this is happening.
The market is reaching levels not seen since 2007, prior to the financial crisis. In December alone, investors removed $55 billion from U.S. funds in fear of the “fiscal cliff”. So far, in January, investors have moved $6.8 billion back into U.S. stock mutual funds.
Bonds are expected to take a price hit if interest rates rise, but the Federal Reserve is full steam ahead with its stimulus measures to keep rates low. Still, investors who have a bond heavy allocation are worried that interest rates are trending upward and their portfolios will soon take a heavy hit. The sentiment, along with a general sensation that the market is doing better is driving investors back into stocks.
What’s wrong with this picture?
Best Case Scenario – Coincidence
We won’t know until next month, but the movements could be explained by coincidental beginning of year activity. People start funding their IRA’s and re-balance their asset allocations early in the year. The influx into stock funds could be happening as investors are contributing money into their 2012 and 2013 IRA’s. Even though markets are at their highs, I immediately invested my entire 2013 Roth IRA contribution into Vanguard Total Stock Market Index Admiral Shares as part of my overall portfolio allocation. Since I am not a market timer and am in for the long haul, it doesn’t really matter what the latest market news is or where experts think the market is going.
Worst Case Scenario – Emotional Investing
There is no doubt that people are emotional when it comes to money. The news that the market is “recovering” is good news to most. Those that pulled their money out of stocks in 2008 are now clawing their way back in. It’s the classic mistake of buying high and selling low. People who have been on the sidelines are watching the market skyrocket and fell left out. They jump back in, hoping to capture the gains when it’s already too late. When the market starts to take a dive, they get nervous and sell at market lows. This behavior is not that of an investor. Buying high and selling low is speculative behavior, and unfortunately represents most of the activity we observe in the stock market. Sadly, this is the most probable reason we’re seeing the inflows into stock funds.
What Should I Do?
Make a plan and stick to it. Investors can prevent the behavior of buying and selling at the wrong times by having a solid plan. Create a written plan with your ideal asset allocation, contribute to your accounts at regular intervals, ignore the media, and stay strong.
Stick with low-expense index funds that track the entire market. You’ll do better than 70%- 80% of actively managed funds. Vanguard founder John Bogle says you should set your bond allocation to your age. You can split domestic and international holdings around that. Benjamin Graham (Warren Buffett’s mentor) says you should have holdings of 25% – 75% in bonds and the rest in stocks. Your percentage depends on your risk tolerance, investment time frame, and how long you will need the money to last (outpace inflation/retirement income). If you’re not sure how to set your allocation, consult a financial advisor.
By using these methods, you will be employing the “dollar cost averaging” and “buy and hold” strategies. Over time, you’ll find that while other people are pulling their hair out over market movements and their losses, you’ll be doing just fine.