In a recent New York Times article, Mark Hulbert discussed an academic research paper that examined market timing using mutual fund flows, specifically mutual fund flows between stock and bond funds. The general premise is a simple one: mutual fund investors are rotten market timers.
The researchers focused on exchanges between equity and fixed-income funds in the same mutual fund family. In line with previous research on money flows into and out of mutual funds, they found that as the stock market rises, investors tend to transfer money from bond funds to stock funds, and vice versa. They also found something that had escaped notice among researchers: that the stock market tends to reverse itself in the weeks and months after these exchanges.
In other words, when mutual fund investors finally got around to switching from stocks to bonds, or from bonds to stocks, things tended to go against them. Paradoxically, stock owners should probably be quite happy that there has been a continuing surge of money into bond funds!
To illustrate the potential benefit of a contrarian interpretation of fund data, the authors built a hypothetical portfolio that, from the beginning of 1984 through 2008, switched back and forth between the Standard & Poor’s 500 index and 90-day Treasury bills. If total net exchanges listed in the three most recent I.C.I. press releases were out of equity funds, the portfolio would be fully invested in the index for the next month. Otherwise, it would hold T-bills.
Over those 25 years, according to the researchers, the portfolio produced an annualized return of 12.0 percent — or 1.6 percentage points a year ahead of buying and holding.
By buying stock funds when mutual fund investors were bailing out of them in favor of bonds, the strategy portfolio managed to outperform-and did so even though it was in cash nearly half of the time.
The bottom line for most mutual fund investors is this: Shift money into or out of your stock funds at your own peril.
Why is the timing of the average investor so lousy? It has to do with the fact that most investor decisions are made on the basis of emotion-they bail out of stock funds when they lose hope. It really is darkest before the dawn, and the article mentions that investors switched money from stocks to bonds right before the historic bottom in the stock market in March 2009. Our entire investment process is systematic and adaptive. Emotions don’t enter into it. Any investment process, including ours, will make plenty of mistakes, but making decisions emotionally will not be one of them.
