Invest for the Next Decade, Not the Last One

Pat Dorsey: Hi, I'm Pat Dorsey, Director of Equity Research at Morningstar.

So with the market up 60-odd percent since the March 9 lows, you'd think there would be a little bit of irrational exuberance among investors, right? Money would be pouring into equity funds; people would be excited about stocks; you'd be getting get-into-the-market-now covers on financial magazines.

In fact, that's not the case.

It's very interesting. I thought this would be the case, and then I went and looked at some of the data on retail fund flows, the amount of money flowing into different kinds of mutual funds, which is typically a pretty good indication of the sentiment among individual investors. I was fascinated to find out that basically, flows into equity mutual funds have been basically flat year to date, and bond fund flows are absolutely off the charts. What this leads you to is a really interesting picture of what I might term the "destructive myopia" of most investors, sadly.

If you go back and look over the past decade or so of fund flows and you look at the money flowing into equity funds, you see it was very high in late 1999 and 2000, and it was fairly low for bond funds. Why? Well, not hard to figure out. During the 1990s, of course, stocks beat bonds in a big way. So what did people do? They look in the rearview mirror, and they plunk lots of money into equities, and they don't put much money into bonds.

Now let's roll the clock forward 10 years to today, and after the past decade, Treasuries have returned six, six and a half percent. Equities are basically flat. So what are people doing? They're pulling money out of equities and putting money in a huge way into bonds, over $300 billion year to date.

This picture becomes very clear if you look at a chart of basically equity flows minus bond flows, and you can see that currently the retail investors' preference for equities less bonds is about at the same levels as October 2002. You tell me, was October 2002, a better time to be buying equities or bonds? Well, equities because equities were pretty cheap right then.

<TRANSCRIPT>

What this really points to is the fact that people's behavior often hurts their investing to a huge degree. A lot of the research Morningstar has done shows that basically the tendency of investors to chase returns and do what they should have done five years ago or 10 years ago subtracts about two percentage points of return per year.

If we are indeed--and I don't know if this is the case, but many people posit it--entering a "new normal" environment of slower growth and equity returns that might be somewhat less robust than that long-term 10 percent average you've often heard of, subtracting two percentage points of return off of a seven percent return, it's not chopped liver.

So it's really worth thinking about right now with generational lows in interest rates and a U.S. government that's becoming increasingly indebted. Is it really the time to be plunging every cent you have into bonds?

Jim Grant, who writes Grant's Interest Rate Observer and is a wonderful observer of the fixed income markets, as well as just a great writer, has termed Treasuries right now basically "return free risk." I think that's actually not a bad way of thinking about them.

Now this is not to say that stocks are wildly cheap right now. If you look at the long run, what you call the "Schiller PE," which is basically a price to earnings ratio based on long-term earnings over a long period of time that's adjusted for inflation, stocks are trading at about an average to slightly above average level.

But in terms of stocks versus bonds, is now really the time to be doing what you should have done 10 years ago, which is be pulling back from stocks when equity valuations were at 30 times on the S&P in 1999 and 2000? Right now, the S&P is at maybe 17 or 18 times. Now, that is not dirt cheap, but it's a much better starting point than where you were 10 years ago.

So it's really worth thinking when you're looking at your asset allocation, do you want to be following the herd and plunging tons and tons of money into bonds right now? Or perhaps are equities, especially good-quality companies that are trading at reasonable valuations, perhaps a better hedge against inflation in the future and a better way to get returns than bonds with interest rates at generational lows?

I'm Pat Dorsey, and thanks for watching.