The Investment Company Institute publishes weekly Flow Reports that show whether investors, overall, are buying or selling equity-traded, closed-end and mutual funds, and in what quantity. If you look back over the years you find that investors tend to buy more equity funds at market cycle peaks and sell more at market cycle bottoms–the classic “buy high-sell low” bad investing dance. The main reason this happens is due to a decision-making rule of thumb known as projection bias, whereby we take what is happening yesterday and today and think the trend will stay the same tomorrow.
This pattern of buy high-sell low was easily seen during the millennium bear market and the Crash of 2008, but if you look at equity fund flows for the last couple of years you see that there is not a clear direction. For a few months there will be buying, then there will be selling for the next few, then buying for a month, then net selling of equity funds the next month. The reason why is that even though the bull market continues, its rise has been very jagged and volatile. The result is that investors are unable to use their projection bias rule of thumb. Granted, it is a lousy rule of thumb, but it at least gave investors the illusion that they knew what they were doing.
A different rule of thumb from the securities world that has greater validity is to move into bonds from stocks when the future looks dire. This made a lot of sense over the last 35 years as interest rates fell and the value of existing bonds increased. In this falling rate environment it didn’t take genius to make money in bonds. If you look at flows since last winter you’ll notice that people have been steadily selling equity funds and, it appears, putting that money into bond funds. This isn’t a bad strategy if interest rates remain flat or decrease, but it may be bad if rates go up.
From 1946 to 1982 interest rates went up. If you had purchased $100,000 of long-term investment grade bonds in January 1946 and sold them in January 1956 you would have gotten back roughly $90,000, or 10 percent less. The reason for the loss is the value of your bonds was lower because interest rates moved up about one half of one percent over those ten years. Let’s say you turned around and did this all over again buying another $100,000 of long-term investment grade bonds in January 1956. If ten years later you again sold them, you’d have received around $80,000 in January 1966.* The reason for the 20 percent loss is because interest rates moved up about one and a half percent during the period. So, 0.5 percent rate increase equals 10 percent loss; 1.5 percent increase equals 20 percent loss. There are those at the Federal Reserve talking about an interest rate target that puts rates roughly two and a half percent higher than they are now. If that happens, how does that buy bonds rule of thumb look now?
There is an alternative to all this. You could simply buy fixed annuities and transfer the principal market risk to the annuity carrier. It’s not yet a rule of thumb, but it looks like it should be.
*Standard & Poor’s High-Grade Corporate Bonds 1945-1982.
