Money Matters: As an investor, should you go with the flow?

By David Peartree

The Daily Record Newswire

Many market observers and investment advisors pay attention to where you invest your money, but they don't mean it as a compliment.

As a group, individual investors are thought to be wrong more often than right and are shown little respect by investment professionals. That's because for many investment professionals, individual investors are the ultimate contrarian indicator.

Individual investors tend to chase past performance, moving their money into an asset class after performance has peaked and then holding on too long until performance inevitably collapses. The actions of individual investors are widely thought to be a guidepost for the astute investor who seeks to do the opposite.

There is a good deal of truth to this, but it is perilous to oversimplify. We can see this if we examine two additional indicators for the long-term investor: 1) money flows and 2) asset class returns. (See "What's on your investment dashboard?", March 17, 2011, for a discussion of additional market and economic indicators.)

Money flows refers to where dollars are flowing in the financial markets. The most readily accessible data is made available by the Investment Company Institute and tracks the flow of dollars in and out of the primary asset classes -- stocks, bonds, and cash equivalents.

Asset class returns refer to how the basic asset classes and sub-classes, perform from year-to-year and over longer periods. The rank of performers from best to worst performing asset classes reshuffles often. For example, according to Morningstar, large cap U.S. stocks, especially growth stocks, were the best overall performer for much of the 1990s.

Since then, according to Morningstar, small cap U.S. stocks and foreign stocks have been the best performing sub-classes of stocks, albeit with substantial swings in performance from year-to-year. Over the past decade, however, bonds have outperformed all classes of stocks.

Like many indicators, money flows and asset class returns are backward looking. What, then, is their utility for the long-term investor?

One is that money flows offer some indication of investor sentiment. Stock and bond performance, at least in the short-term, can be driven by supply and demand patterns. A period of strong flows of money into stocks, for example, can boost market performance.

This is not an endorsement of short-term trading versus long-term investing. However, current trends in money flows might be considered when deciding to re-balance a portfolio. If one believes, for example, that strong flows into stocks will continue for a time, then a decision to re-balance and take profits might be delayed.

A second use of money flows is to remember their potential contrarian nature, but avoid overly simplistic snap judgments. Paying attention to the flow of money in 2000 could have worked well as a contrarian indicator. In early 2000 the last few months of the market peak saw record inflows into stocks.

Unfortunately, those record inflows bought in at peak prices and ran straight into a major market correction. Clearly, too many investors jumped on the dot.com bandwagon too late only to see their investments collapse. Common sense should have said that record inflows into stocks and outsized returns were flashing a signal of overpriced stocks.

More recently, we have seen a similar pattern of money flows into bonds. For much of 2009 and 2010 we saw large net inflows into bonds, and periods of large outflows from stocks. This occurred during a powerful stock market rally. Many commentators have seized on this as evidence that individual investors once again have got it wrong and are again heading toward catastrophe in the form of a bond bubble. (See my response to this claim, "'Bond bubble' talk misses the mark", Feb. 17, 2011.)

Like most indicators, however, money flows should not be viewed in isolation. According to the Investment Company Institute, Baby Boomers represent a substantial majority of investors and comprise the group now heading into retirement. Moreover, stocks still dominate the typical Boomer's portfolio.

I believe it's highly likely that much of the shift into bonds over the last two years reflects Boomers making overdue adjustments to their investment allocation. Having been crushed by two bear markets in the past decade and now heading into or well into retirement, many Boomers are sensibly focused on income and capital preservation. Don't be too quick to go contrarian on this group.

A third reason to understand money flows is because the ability even to track money flows conveys some information about potential risk. Among the many reasons most investors invest primarily in stocks and bonds is that they are two of the most transparent asset classes. We can readily see how much money is flowing in and out of them.

Other areas of the financial markets are much more opaque and potentially risky. In recent years one of the fastest growing areas of the financial markets has been the market for financial derivatives. Derivatives refer to a wide range of financial instruments whose value is based on, or derived from, the price of other securities or other variables.

Finding timely and accurate information about the true net value of money flows in and out of financial derivatives is difficult. This is telling. Remember that credit default swaps, a deep, dark corner of the derivatives market, were a significant factor in the financial crisis of 2008. What you can't see can hurt you, and following money flows within the financial markets is one way to see what is going on.

Finally, the variability of asset class returns from year-to-year is a continuing reminder of the merits of a well-balanced portfolio that is allocated among the major asset classes and appropriate sub-classes. It demonstrates also the risk and possible futility associated with trying to pick the next winner. Better for most investors to have broad exposure to different parts of the markets suited to their objectives.

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David Peartree, JD, CFP® is an investment advisor with Ciccarelli Advisory Services Inc., a registered investment advisor, offering fee-based investment management and financial advice to individuals and families. Offices are located at 110-E Linden Oaks, Rochester, N.Y. 14625; email dpeartree@fscadvisor.com.

Published: Thu, Jun 23, 2011

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