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Even as U.S. stocks trade at some of their highest prices in two years, individual investors continue to sell, leaving the buying to larger players like hedge funds and other institutions. A Nov. 10 Morningstar (MORN) report showed in October another $6.3 billion was pulled from U.S. stock mutual funds, which are used mostly by smaller, retail investors.
A leading expert on investor psychology, Brad Barber is a finance professor at the University of California, Davis, and head of the university's Center for Investor Welfare & Corporate Responsibility. In a Nov. 9 interview with Businessweek.com's Ben Steverman, Barber talked about how he interprets retail investors' reaction to the current rally. Edited excerpts of their conversation follow:
Ben Steverman: Even though the stock market is up, retail investors seem to be sitting on the sidelines. According to Morningstar, investors have pulled $64.2 billion from U.S. stock mutual funds so far this year through October, even after withdrawing $26 billion last year. When might that change?
Brad Barber: My sense is that sentiment for equities isn't going to get positive until the economy is on strong footing. Even though the market has come back, it hasn't really been accompanied by robust economic growth. That can to some degree explain why retail investors remain skittish. The back story of the returns has just not been strong for the last year or two.
By "back story," you're not really talking about the condition of the economy, but the stories that are told in the media about the state of the economy?
Yes, and it's that back story that I think would need to improve to see renewed excitement and participation by retail investors.
Do you think investor behavior is different this time, compared with market rallies after previous recessions?
The more recent crisis certainly feels different. Unemployment rates have been much higher for much longer. The talk on the news is constantly about the weakness in the economy. The Internet bubble bursting in 2000 was a dramatic event, but it was not accompanied by the magnitude of economic dislocation that followed this financial crisis. Losing your job is different from losing a lot of your retirement portfolio.
Does the behavior of these small retail investors have a real effect on the market? Or are they such a small part of the investment pool—alongside hedge funds, pension funds, and other large institutions—that they don't have much impact?
It is true that retail investors directly hold very little stock, under 20 percent [of total shares] these days. There's been a secular shift toward institutions holding investments on behalf of individuals. Having said that, sentiment can also affect institutions to some degree. Direct ownership of stocks by retail investors isn't a big [driver], but it's a good instrument for thinking about the sentiment of the market as a whole.
What is the track record of smaller investors? Do they tend to buy and sell at the right times?
The order flow of small investors perversely forecasts returns. What I mean by that is: If small investors seem to be buying a stock, it tends to forecast poor returns for the stock. Conversely, if small retail investors are selling a stock, it tends to portend strong returns for the stock.
For example, people might become enamored with the latest high-tech startup firms. Retail investors pile in, driving the prices up, but the reality is these companies aren't making earnings. Later, there's a day of reckoning. Conversely, you might have really stodgy, old-line companies, about which retail sentiment is pretty negative. But they're plugging along and posting reasonable earnings. The lack of retail sentiment for those stocks may beat down their prices temporarily, and those low prices would portend strong returns as long as they have earnings to back up the company.
So, sentiment causes fluctuations in prices above or below some level justified by the underlying fundamentals of the company.
Given all the losses investors have experienced, do you expect that Americans are going to permanently change the role stocks play in their portfolios?
There is a lot of evidence that people's attitudes about their portfolios change as a function of market conditions. There is a nice paper by Ulrike Malmendier [an economics professor at the University of California, Berkeley] and Stefan Nagel [a finance professor at Stanford University] looking at how investors allocate stocks in their retirement portfolios.
If you lived through the Great Depression, you're less likely to invest in stocks because you stomached a 15-year period where stocks basically had a zero return. Conversely, if you experienced stocks during the late '80s and '90s—pretty much an unrelenting bull market—you probably were bullish on stocks and tend to have a high allocation of stocks in your investment portfolio. The last decade, of course, has been pretty lousy. And so investors who were saving and coming of age in the last decade are probably going to have lower allocations to stock in their retirement portfolios. The punch line is "experience matters."
So relatively short-term market conditions tend to affect long-term investment decisions. People who came of age in this decade might be permanently much less likely to own stocks?
Or at least have a lower allocation to stocks. In the late 1990s, when I was teaching MBA students, it was hard to convince students that if you held stocks for 10 years that you had any risk of loss. That's not so hard anymore. [Laughter.] The example that I used to try to hammer home this point was Japan, which in the late 1990s had been mired in a 10-year crash. Now it's 25 years and counting.
To what extent is this reluctance to buy stocks rational behavior on the part of investors? And to what extent is it irrational, because investors miss out on stock gains and then, when sentiment finally turns positive again, might end up buying at the top of the market?
It's very difficult for people to understand their ability to tolerate risk until they experience it. It's all well and good to say "I can tolerate the gyrations of the markets." You can sit down with a financial adviser or you can go through online tutorials, but you don't understand until you actually live through it.
Folks go through these times where their portfolios are dropping 30, 40, and even 50 percent, and it causes them to lose sleep. Is it irrational to dial down your equity allocation when it's affecting your sleep and health? I don't think so.
Is it what most economists would recommend investors do? Probably not.
As someone who studies investor behavior, are there questions raised in the last couple of years that you're eager to answer?
The most pressing issue is how investors save and prepare for retirement. This will become even more pressing as we think about solutions to the underfunding of Social Security benefits.
There are a lot of folks doing work on these issues now: How can we get people to save adequately for retirement or make sensible investment choices?