The New Year has started out surprisingly well for equity mutual funds. After years of negative asset flows, both domestic and world equity funds have been experiencing positive flows in 2013. In the first two weeks of January alone, the Investment Company Institute says, domestic equity funds gained $12.75 billion and world equity funds gained $10.9 billion. Inflows have been continuing this month as well.
Is it time for the purveyors of equity mutual funds to rejoice? Is the long drought over? A look at the bigger picture would suggest that celebration is premature. In fact, this mini-trend of positive flows may actually be bad news for the fund industry and anyone else who preaches that serious investors should develop and commit to a long-term investment strategy.
Rather than pursuing a well-thought-out strategy, one can make a strong argument that investors are simply reacting to the current headlines. They are like deer who hear a twig snap in the bushes. They bolt at the first sign of trouble and relax when the noise dies down.
The U.S. stock market just posted its fourth consecutive yearly gain. The S&P 500 Index was up a very solid 16 percent in 2012. This followed a modest gain of 2.1 percent in 2011, another solid gain of 15.1 percent in 2010 and a very strong 26.5 percent gain in 2009. An investor who put $100,000 in the U.S. stock market at the beginning of 2009 had about $172,300 at the end of 2012.
You would think in this environment investors would have been pouring money into the U.S. stock market. We usually chide investors for chasing past performance, but they certainly haven’t been doing that over the past four years. Instead, despite the strong gains in the equity markets, investors have been fleeing equity funds in droves.
Actively managed U.S. stock mutual funds experienced outflows of $134 billion in 2012, making it the worst year ever for such funds. Even worse than the $132 billion outflow in 2008. In fact, U.S. equity funds have experienced significant outflows for each of the past four years.
A number of explanations have been offered to explain this trend. One is that changing demographics are driving aging baby boomers to lighten up on equities as they age. Another is the rapid rise in popularity of exchange-traded funds. No doubt, these are contributing factors. But I believe there is an even more fundamental force at work here.
Fear. Fear of the European debt crisis. Fear of hurtling over the fiscal cliff. Fear that our government has lost its ability to solve our problems. Fear that there is another 2008-like monster hiding under the bed. Fear underscored by wars, theater shootings, school shootings and devastating storms that show us we are not totally in control of our fate.
All this gloom and doom significantly affects our perceptions of the world. In surveys conducted by Franklin Templeton Investments at the end of each year, 66 percent of investors thought the market was down or flat in 2009, 49 percent thought it was down or flat in 2010 and 70 percent thought it was down or flat in 2011. Their moods clearly distorted their realities.
Recently, the winds have shifted a bit. At the last possible moment Congress took action to avoid the worst-case scenarios associated with the fiscal cliff. It even exhibited what looked like a rare flash of cooperation and raised the debt ceiling for a few months to allow time for discussion. The divisive election is behind us and instead of mud-wrestling politicians, headlines featured Michelle Obama’s inaugural gown by Jason Wu. It looks increasingly like the Europeans will find a way to avoid cratering the global economy. President Obama announced an acceleration of troop withdrawals from Afghanistan. The 2008 market meltdown looks smaller in the rearview mirror. And did I mention that equity mutual fund flows turned positive?
Who knows how long these good vibes will last? Unemployment is still high. Our economy still seems fragile. There is no solution in sight to our national debt and deficit spending problems. There have not been any sightings of Republicans and Democrats sitting in a circle singing Kum Ba Yah. The world is still a very dangerous place. here is no telling what tomorrow will bring.
During another bleak period of our history, Franklin Delano Roosevelt said, “The only thing we have to fear is fear itself.” He uttered these words 80 years ago on the occasion of his first inauguration in 1933 when the nation was in the grip of the Great Depression. FDR was not trying to minimize or dismiss the difficulties that confronted our country at the time. Instead, he was trying to help people gain perspective during one of our darkest times. He knew that one key to dealing effectively with any situation is to not let your emotions get the best of you.
Pogo, the main character in Walt Kelly’s classic comic strip of the same name, said: “We have met the enemy and he is us.” Certainly this is true for investors who allow fearfulness to dominate their decision-making process. Those who have been exiting the U.S. stock market for the past 4 years are proof of that. They missed out on unusually good stock market returns. Those that are jumping back into the stock market based on the fair winds that seemingly now prevail may also regret letting their emotions influence their investment decisions.
It is hard to avoid getting swept away by the headlines of the day. In the United States today, there are approximately:
- 13,000 newspapers (1,400 of them are delivered daily)
- 20,000 magazines
- 15,000 radio stations
- 1,800 full power TV stations (and many more low power stations)
The average household receives 118.6 TV channels. News flows 24/7.
Then, of course, there is the Internet, which conveys news through e-mails, Web sites, blogs, pop-ups and social networks in staggering volume. There is simply no way to measure the number of units of good and bad news to which we are subjected every day.
So, if we can’t avoid the headlines, how do we at least prevent ourselves from being unduly influenced by them in making investment decisions? Here are some thoughts that may help.
Headlines and stock market returns are not correlated. The world is, and always will be, full of problems. Those problems will be prominently featured in the headlines. There isn’t room here to catalog all the ugly headlines I have read in my lifetime, but a dollar invested in the S&P 500 Index in 1951, the year I was born, has grown by over 55,000 percent — an annualized return of 10.7%. Likewise, there is no evidence that happy-go-lucky headlines are precursors of rising markets.
FDR was right — fearfulness undermines good decision-making. It engages the ancient part of your brain that houses the “fight or flight” response, which is a vestige of our primitive past. When making investment decisions, engage the rational, analytical part of your brain. If there is reason to be concerned or cautious, act accordingly. But don’t act emotionally or out of fear.
The herd is almost always wrong. Warren Buffett said: “Be fearful when others are greedy and greedy when others are fearful.” I wish he had said “Be cautious when others are greedy,” because I don’t think it is ever a good idea to be fearful in investing. But his basic premise is right on target. There is comfort in the herd, but if you want to invest successfully you must be willing to step outside of that comfort zone and go against the herd.
The world of investing is hard enough as it is, and there are many things that are beyond our control. But we can control how we behave in the face of the headline-tsunami that washes over us every day. If you give in to your fears and emotions and get caught up in the mood of the crowd, like Pogo, you are likely to find the enemy staring back at you in the mirror.
Scott A. MacKillop is president of Frontier Asset Management, a firm that constructs and manages portfolios for financial advisors and their clients. He is a 36-year veteran of the financial services industry.