Market Dive Tests Mettle of Mutual Fund Investors
A widely held tenet on Wall Street today is that millions of small investors will jump into the stock market if prices tumble, because people know instinctively that “buying on dips”--especially via mutual funds--is the smart thing to do.
And in so doing, those investors will keep the market from spiraling into some horrendous decline.
Won’t they?
In fact, some evidence from the past few years suggests a bleaker scenario. Even modest declines in some markets in the 1990s have frightened individuals enough to cause many of them to either pull back sharply from mutual fund purchases, or to trigger outright selling.
That evidence is a cause for worry now on Wall Street, which between Thursday and Monday suffered the deepest two-day market slide since late August 1990--a 300-point, 4.3% plunge in the Dow Jones industrial average.
On Tuesday the market stabilized, with the Dow gaining 27.57 points to 6,611.05. But with the average stock mutual fund losing 2% in the quarter ended Monday--the first quarterly decline in more than two years--questions about the stability of the $1.8 trillion in stock fund assets are once again dogging the market.
To be sure, stock mutual funds alone don’t control the stock market. They represent only about 20% of the U.S. market’s total asset value. Still, the funds have mushroomed in size and power during the last two years as individuals have pumped an unprecedented $348 billion in new cash into them.
And because fund purchases and redemptions (withdrawals) are easily tracked, those data have become closely watched as a gauge of small-investor sentiment toward stocks.
If fund investors were to turn decidedly bearish, resulting in heavy redemptions, the mere publicity about that trend could have ramifications far beyond the actual effect of the funds’ stock sales.
So far, major mutual fund companies say small investors have been unfazed by the market’s recent decline and that there haven’t been any significant redemptions from stock funds overall.
Even so, there is clear recent evidence that the notion that fund investors automatically “buy on dips” is flawed:
Many “aggressive growth” funds that focus on small-company stocks and other typically high-risk, high-return stocks, have been in a steep decline since last spring, preceding the plunge in blue-chip issues that drove the Dow index down in recent days.
But rather than buy more of those aggressive growth funds at cheaper prices, many investors now are pulling money out of them.
Data from the Investment Company Institute, trade group for the mutual fund industry, shows that while gross purchases of aggressive growth funds were up 16% in January and February from the same two months of 1996, to $18 billion, redemptions rocketed 89% year over year, to $12.2 billion.
Moreover, many fund companies say that trend grew more pronounced in March as smaller stocks’ plunge deepened.
The aggressive funds’ faded appeal with investors, even as the funds’ shares fall to levels that Wall Street analysts contend constitute bargains, is reminiscent of investors’ quick mood change regarding other markets that have fallen on hard times in the 1990s.
“Emerging-markets” stock funds, which own stocks of developing countries, dove in 1994 as key markets plummeted. That triggered the fast exit of many investors from those funds--driving assets of the Fidelity Emerging Markets fund, for example, from $1.9 billion in 1993 to $1.1 billion by the end of 1995.
Much more troubling for the fund industry were the actions of bond mutual fund investors in 1994. A continuing slide in bond fund share values in that year, as the Federal Reserve Board doubled short-term interest rates over 12 months and thus depressed the value of older, fixed-rate bonds, sparked a dramatic investor exodus from bond funds that lasted well into 1995.
While investors pumped a net $11 billion in new cash into bond funds in January 1994--just before the Fed began to raise rates--over the following 11 months the funds lost a staggering $55 billion to redemptions, as investors fled. That helped push bond yields higher, as the market went begging for buyers.
Exactly at the point that yields on new bonds reached their highs for the year, in November 1994--the time investors should have been buying bond funds to lock in attractive yields--redemptions from bond funds also reached their peak, as $11 billion flowed out.
Could the same thing happen with general stock mutual funds, should the market’s current decline worsen? Many Americans, of course, have told themselves that they are long-term investors, and that they won’t sell their stock funds no matter what happens to share values in the short term, and that they would probably buy more if prices fell.
That view has been widely espoused by baby boomers who are saving for retirement 10 to 30 years down the road, and have no reason to sell stocks now.
But analysts suspect that, in a decade in which the market has mostly risen and rarely fallen, many people have badly underestimated their threshold for psychological pain should their mutual funds begin a sustained decline.
“Fear is the strongest human motive,” said Kenneth Doyle, a financial psychologist at the University of Minnesota. Investors, he said, have the same biological reaction to perceived danger in financial markets that they would to the threat of physical harm: If it’s scary enough, they will flee.
“The head may say, ‘This is the right time to buy,’ but the gut reaction is ‘then [let someone else] go first,’ ” Doyle said.
Don Phillips, president of mutual fund rater Morningstar Inc. in Chicago, believes that despite many investors’ inherent belief in long-term investing--and in buying more when securities prices are down--in practice that belief is sorely tested when markets actually move against people.
“The ‘buy low and sell high’ concept is not hard to understand, but it is phenomenally difficult to master,” Phillips said.
John Rea, researcher at the Investment Company Institute, said the fund trade group’s surveys show that for most fund investors, the reaction to a market decline is simply to do nothing: The majority don’t buy or sell, but sit still.
Even though investors may sense that securities are at bargain levels, Rea said, “buying on dips” tends to be limited until investors believe that it’s safe to do so.
What that usually means is that buying doesn’t accelerate until prices begin to climb again--if they do. Small investors go back into a market “after you have a limited downward move, and then a bounce,” said Michael Lipper, head of fund-tracker Lipper Analytical Services in New York.
What hasn’t been tested in the 1990s is stock investors’ reaction to a prolonged, as well as deep, U.S. market slide. Because the vast majority of stock fund investors have only owned funds since 1990, they have never experienced a broad-based bear market, usually defined as a decline of 20% or more in major stock indexes.
The feared scenario is that share prices drop, fund investors pull back from new purchases and redemptions climb--forcing fund managers to dump stocks, worsening the market’s decline. That, in turn, could plunge more investors into a fearful mind set, raising the likelihood of panicked selling by people who had considered themselves long-term share owners.
Of course, because millions of people invest in mutual funds via retirement accounts, such as 401(k) plans, that money is viewed as harder for them to reach and manipulate. Yet the trend among 401(k) plans is to increase the ease with which they can make spur-of-the-moment changes.
What happened in 1988, following the October 1987 stock market crash, still worries many market analysts.
Relatively few fund investors sold into the crash. But stock funds experienced net redemptions for virtually the entire year afterward--even as stock prices overall climbed.
Individual investors clearly made the wrong mass decision then to sell; they should have been buying stocks at bargain prices.
That the stock market was able to rally in 1988 even in the face of fund redemptions was partly because stock funds were then a much smaller force in the market.
Today, twice as many Americans are share-owners as in 1987, and many of them own stocks exclusively through funds.
Thus, whether fund investors “buy the dips” going forward--or instead, sell into them--will have a far greater bearing on whether the 6 1/2-year-old bull market sustains itself, or begins to implode.
