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Investors Favoring Stocks Over Bonds

Investors are buying stocks. The level of stock ownership as a share of portfolios is at a level only seen in 2000 and 2006-2007. The share of mutual fund investments in stock funds is almost 62 percent, according to data from the Investment Company Institute (see chart below).stocks bonds graphic

It makes sense that investors are favoring stocks. Bond yields are low, the economy looks healthy, and consumer sentiment is strong. Strong stock performance has also pushed holdings as a share of the portfolio upward. However, we urge investors to exercise caution.

Historically, when stock exposure peaks is precisely the time that investors should expect reduced future returns. There is a strong negative correlation between the share of investments in stocks and subsequent stock returns. Here’s the problem facing investors: If the historical pattern holds, they may be looking at several years of below-average stock returns. But the typical alternative, bonds, may be offering zero or even negative returns after inflation.

Here’s another problem: There is no good way to time precisely when stock markets will regress. The correlation between stock ownership and subsequent 1-year stock returns is negative, but not strong. In other words, high stock ownership usually leads to lower 7-year returns, but only sometimes does it lead to lower 1-year returns. Given the strength of the underlying economy and the fact that we don’t have a recession on the short-term horizon, most analysts predict higher stock markets over the next year, but that’s no guarantee.

This is not to say that investors with a traditional 60/40 stock/bond portfolio should change allocation. However, they may want to temper return expectations over the coming several years. Maintaining a portfolio allocation in line with risk tolerance will help long-term investors overcome behavioral issues such as chasing returns by selling stocks after the market falls and buying after the market rises.

We encourage investors to maintain a long-term focus and a suitable risk exposure, which probably includes an allocation to safer assets such as bonds, treasuries, cash, gold, or other commodities in order to temper short-term volatility. We have found that when it is most painful for investors to hold such instruments (during the peaks of 2000 and 2007) is exactly the time that they should be held.

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