Investor trauma and the recency effect

Back in May I wrote a post talking about “investor disgust” with the stock market. You would think that an 11% return in the S&P 500 in the interim would have cheered investors up. However signs continue to accumulate showing individual investors shunning the stock market. I argued that his investor disgust is the foundation on which a new, secular bull market is being built. From our earlier post:

One could also argue that (secular) bear markets don’t end in panic, but rather in disgust and there seems to be plenty of disgust in the stock market to go around at the moment. At some point in the future some sort of normalcy will return to the financial markets and the question will be how you will have positioned yourself in the meantime.

In the meantime we have seen more signs of individual investors fleeing the market.  A recent survey shows that a majority of individual investors were unable to correctly identify the fact that the S&P 500 had been risen in calendar years 2009, 2010 and 2011. At Fidelity Investments a recent milestone shows that the firm now manages more in bond and money market funds than it does in equity funds.

Today in piece at the Wall Street Journal by E. S. Browning more evidence that individual investors who were so traumatized by the declines of 2008 are simply unwilling to recommit to equities as a cornerstone of their portfolios.  The signs of “disaffection are widespread” and include continued outflows from equity-related funds and ETFs, reductions in equity holdings in 401(k)s and simply more households holding fewer equities. Most of all investors seem traumatized from the seemingly existential declines markets experienced in 2008. From the article:

“People are scared stiff to go through an ’08 again,” said Mark Pollard, a financial adviser in Princeton, N.J., with Merrill Lynch Wealth Management. “People do talk about that: ‘Whatever you do, I don’t want to go through an ’08 again.’ “

We will go through another 2008 at some point. That is what markets do. However the recency effect is likely pushing investors to overweight the probability of another such (traumatic) event happening sooner rather than later. In the meantime they risk missing out the ongoing return to equities, especially in light of the particularly poor prospect for most fixed income assets.

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