Moving out of equities

By Felix Salmon
July 12, 2010
Jim Browning has a big story today saying that small investors are "fleeing stocks" and "running for cover". And interestingly, this is not a particularly new phenomenon, and it predates the big crash of 2008:

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The WSJ’s Jim Browning has a big story today saying that small investors are “fleeing stocks” and “running for cover”. And interestingly, this is not a particularly new phenomenon, and it predates the big crash of 2008:

flows.gifAfter getting hurt in the 2000 tech-stock crunch, individuals came back to U.S.-stock funds in 2003, as stocks were entering a new bull market, ICI data show. But the buying proved tepid and turned to net selling in the latter part of 2006, even before the bull market ended in 2007. Despite occasional periods of inflows to U.S.-stock funds, the selling trend has continued since then.

It’s only natural for buy-side types to look at this data and conclude that this is a great buying opportunity — but I’m not so sure. Browning concentrates on investors who are rotating out of equities by choice, but I suspect that a lot of what’s going on here is a matter of necessity: people are selling their stocks because they have to, not because they want to. After all, they no longer have the ability to take out home equity lines of credit whenever they run into a liquidity crunch.

There’s also a certain amount of delevering going on, which is encouraging: Browning talks of one investor who sold a third of his stocks and used the proceeds to pay down the mortgage on his second home. Sensible.

And while Browning talks of the new conservatism as emblematic of the way in which the stock market is being left to large institutional investors, the fact is that underneath their monolithic exteriors, those big investors are mostly just aggregations of little investments at heart. It’s entirely possible that retail investors are ahead of the curve, here, and that institutions will end up following suit: what are the chances that they will continue to see inflows rather than outflows, over the long run?

What’s undeniable is that it makes a lot of sense for the “comfortably retired” Karen and Roger Potyk to sell their stocks. If you have enough money to live on, why take the risks associated with equities? Especially when doing so makes you feel bad about yourself morally?

“In the military, you learn that you want people you can respect, trust—who have integrity,” Mr. Potyk says. “Over the last five years or so, I find that our financial institutions have no shred of the character I describe.”

The last straw was the May market volatility, accompanied by widespread fears about European government debt. On May 20, the Potyks asked their financial adviser to sell the last of their stock mutual funds.

Now that their portfolio consists entirely of fixed-income investments, “I won’t make 8% on my money. I will make 4% or 5%, but the money will be there,” says Mr. Potyk.

It’s worth noting here that Mr Potyk still thinks of stocks as something which can and should return 8% a year, despite the fact that they’ve done nothing of the sort for the past decade. In that sense, we haven’t had a real capitulation yet. It’s rational to exit the stock market even if you think it’s going to go up, so long as you also think there’s a serious risk it’ll go down, and you can’t afford to lose that hard-earned money. But for the time being, in the public mind, stocks are still things which go up over time. Which says to me that there’s still at least as much downside as there is upside.


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4-5% a year on your money without risk? tell me where to sign. 30 year treasury bond sits at 4% with 30 years of inflation risk.

Posted by AtTheMargins | Report as abusive

Some people live in the real world, apparently, and some may be heading back to it.

Posted by yr2009 | Report as abusive

A portfolio consisting entirely of fixed-income investments? Wow!!! How will Mr. Potyk fare if we go through ten consecutive years of 7% inflation? Does anybody here find that scenario unthinkable? He is taking a HUGE risk with that investment strategy, even assuming that those bonds he holds don’t default.

I suspect he is making a mistake common to most small investors — they assume that the future will mirror the past. Over the past twenty years, interest rates have been falling and inflation has been tame. Thus Mr. Potyk can’t conceive of the risk that RISING interest rates and HIGH inflation pose to fixed-income investments. And, of course, the stock market has been weak over the past decade, so Mr. Potyk can’t conceive of the possibility that the situation might change.

I do agree with Felix on one point — most stock analysts take an unrealistically rosy view of the long-term market prospects. Not only does that get in the way of sensible retirement planning, but it warps investment strategy by encouraging leverage (and investment in leveraged corporations) and chasing pie-in-the-sky dreams of growth. THESE WON’T MATERIALIZE!

My own approach aims for long-term stock returns that are 4% ahead of inflation, a target that I believe I have a very high probability of hitting with my portfolio. It isn’t hard to find companies with a 3.0% plus dividend yield and predictable 5% annual growth. Any tyro investor can do THAT. The only hard part is resisting the temptation to try doubling your money in five years. Do that and you end up taking on R-I-S-K.

I’ve averaged roughly 4.5% compounded returns on my retirement portfolio since Jan 1, 2007, with 75% to 80% invested in stocks AT ALL TIMES. No options, derivatives, or complex arbitrage strategies. It isn’t magic, it isn’t luck, and it isn’t anything you can’t do yourself if you stop gambling with the market.

And it is a whole lot less risky than putting 100% of your wealth into a single vulnerable asset class.

Posted by TFF | Report as abusive

In 1972, Mr. Potyk might have purchased 30 year treasury bonds with a yield of 6%. Ten years later, the 20 year treasury bonds were yielding over 11%, implying a market value of just $600 per bond. Of course he was still getting those $30 payments every six months, right? Slight problem — the CPI more than doubled over that span, so those $30 payments now had the purchasing power of $13. To me, at least, that kind of double-hammer would be a budget buster.

I’m guessing that Mr. Potyk’s doctor has given him just five years to live. In that case, owning 100% bonds makes perfect sense.

Posted by TFF | Report as abusive

This piece is spot-on. The old idea that equities are best in the long run was based on a Western-world economy dominated by the US. I’ve been anti this idea for seven years now and gone to the asset class with the best signs rather than stock markets fuelled by ignorant traders and directionalised by dubious investment firms. My fund is 37% up, and there are millions like me.
Crash 2 is coming, because nothing was done to deal with the causes of Crash 1. stment-hedge-funds-are-driving-this.html

Posted by nbywardslog | Report as abusive

I share the point re equities – that expectations are too high. yet, if it’s retirement investment, in my case for another 30/40yrs – I can’t see how anyone would seriously considerer rotating 100% into fixed income. This, to me, is a crazy strategy. And easy – fairly cheap strategy is to go 50% equities, 25% fixed income, 25% cash. You can tweak those, and take HY instead of A rated bonds, or international equities rather than S&P if it takes your fancy, but always look at the funds fees – ie: forget about outperformance, focus on costs.
The point is that whether equities will go down from now on, i will be buying a bunch of them now, next month, the year after etc… and my contribution will be the same % of my salary. This pound cost averaging esentially removes a lot investment risk – that risk that I mess up my timing etc.. As I don’t have a cristal ball, I’m quite happy with that approach.

Final point: whether one likes is or not. Equities are the foundation of investments. In an over-indebted world, fixed income is unattractive to me. (especially with ZIRP) Ok, to HY debt, and equities and cash, but IG or Govs – I think the yield is too low, the risk of that returns being destroyed when rates go up is just too high for my liking. Fixed income portfolios will be annihilated, just like equities have, and the past if full of dismal years for bonds – I just don’t know when.

In my view, sovereign are the worst. It is a huge bubble. Not fuelled by greed – but by fear: the fear of losing money – see the Potyks.

Posted by fxtrader14 | Report as abusive

I read the WSJ article and agreed with Potyks’ decision 100%; indeed, I moved the last of my money in equities out of the market mid-May, days after the flash crash. And, yes, I’m a senior, but not one who relies on my investments for income; I have a healthy pension to live on and use the investments for special expenses and to share with my children when I die.

That said, what irritated me about the WSJ article was its characterization of the Potyks’ (and others’) decisions as “a flight from risk.” I view my decision as a flight from fraud, deception, gross mispresentation, and grand theft larceny. As a small (but 7-digit) investor, I am being lied to by the companies about their financial condition through loose interpretations of porous accounting standards–and sometimes straightforward deception. I am being cheated out of a fair price on my holdings by proprietary HFT that intercept my my orders and add costs that adds no value. Moreover, almost every day, this HFT manipulates the market in at least the final half-hour to achieve propriety goals through trading on an ever decreasing number of index stocks in an ever smaller trade volume. I am being cheated by the USG (specifically the SEC) by not getting to the root of the “flash crash” that destroyed billions of dollars in value and sucked liquidity out of the market (and was HFT driven in my view) and fixing it. Instead, we got a shoulder shrug and a containment policy (short-term trading stops).

I am aware that the inflation is a longer term risk, but I think deflation is the greater short term risk. Accordingly, I’m heavily invested in bonds (UST, corporate, and muni) and CDs. I would not hesitate to move my investments if I sensed the threat of inflation was significant, but I’m both receiving a healthy return and some confidence in their stablity.

Even if inflation returns, I will not return to the stock market unless all the ways that the deck is now stacked against the small strategic investor are resolved. Right now, it’s a crooked house with the help of the USG police.

Posted by Lilguy | Report as abusive

“And easy – fairly cheap strategy is to go 50% equities, 25% fixed income, 25% cash.”

That’s a pretty solid strategy for somebody in retirement, though the “cash” allocation is too high for somebody with a long-term horizon. (Unless you plan to use that cash for opportunistic buys.)

An investor willing to put in a little time ought to hand-pick those equities, however. The stock market is not a monolith — there are different segments with very different characteristics. If you wish to put principal-protection ahead of potential pie-in-the-sky gains, you can easily construct a portfolio of 10-15 blue-chip stocks that will provide decent industry diversification and strong downside protection, and the transaction costs needed to implement such a strategy are comparable to the fees charged by index funds.

“This pound cost averaging essentially removes a lot investment risk – that risk that I mess up my timing etc.. As I don’t have a crystal ball, I’m quite happy with that approach.”

Absolutely! This is why I don’t cite my results going back a full decade — I was still working/saving heavily at the time, and so I rode much more money on the “upswing” than on the “downswing”. Dollar-cost-averaging works very well in a volatile “V”-shaped market.

“I am aware that the inflation is a longer term risk, but I think deflation is the greater short term risk.”

Both are risks — and my crystal ball isn’t working so well right now. Any strategy that will get torpedoed by one or the other is a broken strategy.

And Lilguy, you are far too concerned about HFT, hedge funds, and the “flash crash”. They all operate in the short-term markets. Because of their strong presence there, it is almost impossible for a small investor to profit from short-term trading. (Unless they are smarter than those hedge-fund gurus.)

Instead of worrying about the daily (hourly?) movements, keep your eyes fixed on the horizon. If you look three to five years out — it is difficult to look farther than that — you’ll find that the landscape is much more serene. The big guys aren’t interested in any investment that takes longer than a single quarter to realize.

If you can achieve your financial goals without stocks, then more power to you! Just consider the POSSIBILITY of a variety of different scenarios, including stagnant domestic growth and/or inflation. A solid portfolio should produce respectable results under all scenarios. There is no portfolio that will outperform the markets in every scenario. There is always SOME lopsided portfolio that will beat you. But if you refuse the potential for massive growth, you can dramatically trim the downside risk.

Posted by TFF | Report as abusive

Yeah, so I thought I’d chime in, just because I’m one of those guys shifting from stocks to a more balanced portfolio. I will admit that I was like 90% stocks in 2008–had been my whole professional life–and I rode the elevator all the way to the basement. Now, I didn’t want to do anything rash, but I decided it was time to think a bit differently about asset allocation in the future. I spent my time last year thinking and studying and working on financial no-brainers like refinancing the house…all the while the markets were rising, too, which was no small comfort.

By January, I had come to the conclusion that I wanted a portfolio of about 40% debt and 60% equity, and I’ve been moving to that allocation all year. I find that leaves me just about equally nervous about rising interest rates and falling stock markets. Perhaps that’s progress.

Posted by ckbryant | Report as abusive

Good move, ckbryant! There are very few people who belong with a portfolio of 90% stocks.

In addition to domestic stocks and traditional bonds, consider if there might be an appropriate role for international equity, regulated utilities, commodities or commodity producers, inflation-protected securities, REITs, and/or shorter-term notes? For every investment class there is SOME scenario under which that investment will perform well. The least vulnerable (not necessarily most profitable) portfolio is the one that appropriately balances/hedges the most bets.

Posted by TFF | Report as abusive

Nice of you to have a kind word for me, TFF. Right now, my equity portfolio is about 10% REITs, 60% domestic stock (broad indices, so a couple of percent of _that_ is REITs, too…), and 30% non-US stock. That’s a simplistic allocation that comes out of Bernstein’s _Investor’s Manifesto_, and I’m fairly comfortable with it at this moment. I try to learn more from month to month; I guess we’ll see how smart I’ve become in a few more decades…

Posted by ckbryant | Report as abusive

ckbryant, a high comfort level with your approach is perhaps the most important piece of any investment plan. The people who REALLY do poorly are those who are constantly panicking when the market cycle turns against them, chasing yesterday’s returns and finding that they consistently catch tomorrow’s losses.

If you stick to index investing, your current approach is sound. However, I would encourage you to at least consider the possibility of picking your own domestic stock portfolio. Because the S&P500 is dominated by the mega-caps anyways, you can restrict your attention to the big names without significantly altering your investment universe.

The reason for investing in index funds is the (essentially accurate) premise that no strategy will consistently beat the market by a significant margin. However the flip side of that is equally accurate — no sensible strategy will consistently UNDERPERFORM the market by a significant margin (assuming low transaction fees and no tax implications).

Thus my strategy is focused on quality companies, sound management and accounting practices, easily understood businesses, and modest, predictable growth. I won’t beat the market with this strategy — but I’ll capture a majority of the positive returns with roughly half the downside in any crash scenario. My portfolio with 80% stocks is actually less volatile than an index-based portfolio with 60% stocks (and I’m betting will have superior returns in the long run).

Those who view the stock market as a (toppling) monolith are tarring with a broad brush… If you explicitly set out to reduce risk, you can construct a balanced portfolio that successfully reduces risk without sacrificing much of the upside. I will absolutely lag the market if it goes on a 20-year bull run, but if THAT happens I’ll never live long enough to spend my savings anyways. I’m more concerned with getting a reasonable ROI in scenarios involving economic stagnation and/or turmoil.

Posted by TFF | Report as abusive