Resisting The Urge To Trade

August 23, 2011

Flows indicate investors dumped ETFS in the past week of intense volatility. Unfortunately, that’s exactly what they shouldn’t be doing.

History tells us it’s just about inevitable that retail investors will flee a dropping market. Still, I can’t help but be bothered by it. Last week—the fourth in a row where we saw world stock markets tumble—investors in equity ETFs pulled up their stakes and ran. A total of $935 million flowed out of stock-holding ETFs in those five days alone, according to data compiled by IndexUniverse.

The reason it bothers me is that index funds should—at least as far as retail investors are concerned—be long-term holdings. To see people abandon long-term positions because of a few down weeks is disheartening. They’re falling prey to “buy-high-sell-low” emotional reactivity that has hurt small-guy investor returns since the beginning of time.

And it’s not just ETFs, which some critics such as Vanguard founder John Bogle say are too easy to trade. It turns out mutual funds have done no better, losing tens of billions in recent weeks, according to the Investment Company Institute, the industry trade group.

Interestingly, during the past week’s frenzied market action, ETFs as a whole gained assets to the tune of $1.5 billion. By and large, ETF money flowed out of equities and into funds favored by the frightened and the bearish that hold gold and bonds.

Shaken investors who simply wanted to take their money off the table shifted into precious metals and short-term bond funds. Meanwhile, from the truly bearish, we saw hundreds of millions flow into the ProShares Short and UltraShort S&P 500 funds (NYSEArca: SH) and (NYSEArca: SDS). Both offer inverse exposure to stocks that make up the S&P 500.

How much of that is institutional money making a short-term play is impossible to tell, but typically retail investors don’t dabble heavily in inverse or leveraged funds.

 

ETF Flows: Week ending 8/19/11

ETF flows for the week ending Aug. 19.

 

The problem with this shift into the risk-off funds is that most equity investors should be looking at long-term returns, say, 10 to 20 years into the future.

Taking the long view, a few weeks of a down market is just a small blip on the graph.

But rather than ignore short-term gyrations in their long-term allocations, investors have rushed headlong into funds that don’t look very attractive over the long haul. Gold prices are at record highs, which is generally not the right time to buy into a commodity.

Meanwhile, as Gene pointed out in his blog on Monday, short-term Treasury funds like the SPDR Barclays Capital 1-3 Month T-Bill ETF (NYSEArca: BIL) currently offer zero return. Those investors are essentially hiding cash under the mattress.

While the rollercoaster moves of U.S. stocks have no doubt been stomach-turning, the alternatives don’t look too rosy either.

I don’t claim to know where the markets are headed, but I can’t help but think that long-term investors would be best served by staying put during market jitters. Instead, at least some have let their fear take hold, selling their shares at the lowest prices stocks have touched all year.

 

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