Why investors mis-time markets -- and how you can avoid their mistake

why-investors-mis-time-markets-and-how-you-can-avoid-itFor millions of mutual fund investors, Dow 10,000 was an awkward milestone. In October alone, as markets crested following an eight-month run-up in stock prices, investors put the largest monthly amount into bond funds since 1984 -- a record $48.4 billion. Meanwhile they yanked $15.5 billion out of their domestic stock funds, according to California-based TrimTabs Investment Research, which tracks investment flows. So far this year, retail clients have poured a record $327.2 billion in new investments into bond funds.

It's more than just profit-taking. "It's been a consistent investor response all year, and that's been 'stick as much money as you can into a bond fund,'" according to Charles Biderman, chief executive of TrimTabs. If history is any guide, they'll soon find they've made yet another investing mistake when bonds crater, as they will once the Federal Reserve begins hiking interest rates.
Remember the bear market in bonds in 1994 -- what Fortune called at the time "the great bond market massacre"? On average, investment grade bond funds lost 3.2% that year, according to Chicago-based Morningstar, Inc. (MORN). Nonetheless, stock funds showed a slight boost last week, gaining $1.6 billion through Thursday while bond funds attracted $3 billion.

Are investors dumb? Scared? No, just shortsighted and lazy, according to behavioral economists, who study the intersection of psychology and money. Research shows that investors value recent past experiences more than earlier ones and tend to follow trends. In one study published in 1998 looking at mutual fund flows, Erik R. Sirri and Peter Tufano found that top-performing funds attract the most money because consumers gravitate toward funds that are "easier or less costly for them to identify."

Biderman puts it more simply: "People invest with their eyes on the rear view mirror, their hands on the steering wheel, their foot on the gas," he says. "And they wonder why they have major crashes every few years."

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