Editor's Note

06/28/2007 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

June 28, 2007

The news media are full of stories about big institutions bailing out troubled funds, avoiding dicier deals, suddenly losing their appetite for risk.

So, is it any wonder individual investors have been cautious?

In fact, individuals appear to have been largely on the sidelines throughout the rally that lifted the Standard & Poor’s 500 24% from its lows last July through its recent record peak.

For months, the pundits on CNBC and other outlets have bemoaned individuals’ lack of participation in the markets. Bernie Schaeffer, chairman and CEO of Schaeffer’s Research, said in a recent address at the Las Vegas Money Show that if the stock market is in a bubble, it may be the first mania in history in which individuals did not join in.

So, what’s going on?

The speculators and day traders who grabbed the headlines in the late 1990s were wiped out or moved on to real estate or other fast-buck schemes, leaving more serious investors behind.

Those investors, burned by their experiences in the dot.com crash, are a more sober, risk-averse bunch. They’ve continued to build wealth but really believe in diversification and act accordingly.

Meanwhile, the rise of defined-contribution retirement plans has given individuals many more choices on how to invest. And exchange traded funds (ETFs) have absorbed some of the animal spirits of active investors who previously might have taken a flyer on individual stocks.

The numbers tell the story—specifically the first-quarter financial statements of online brokers Schwab and E*Trade.

The key statistic analysts look at are called DART—daily average revenue trades, which comprise all client trades that generate trading revenue.

At E*Trade DART fell 11% in the 12 months ending March 31 (the most recent quarter available), while at Schwab it tumbled 16%.

During that same period, the S&P 500 rose about 10% and many international markets did much better.

If that money didn’t go into stock trading, where did it go? One hint: Schwab’s mutual fund service fees jumped 16% in the same period, suggesting that some of it found its way into mutual funds (most likely international funds, which attracted nine out of every ten dollars invested in stock mutual funds last year).

But investors may have stashed much of it in CDs or money market funds or under the mattress amid market shocks like last May’s global correction and February’s selloff in China, which hit US markets, too.

John Markese, president of the American Association of Individual Investors, thinks those events brought back bad memories of 2000. “What drives people into the market is sustained low volatility,” he says. “I think that [choppy markets] frighten a lot of people.”

Markese says AAII membership is higher than it was in the dot.com days, but members tend to be in their mid- to late fifties, when retirement is in sight, appetite for risk wanes, and capital preservation becomes more critical. Not surprisingly, he finds members are more interested in broader retirement-planning products.

Similarly, employers are offering more and more choices in their retirement plans, including more index funds and life-cycle funds. (Pick a retirement date—say, 2025—and leave the driving to the fund managers, who reduce the percentage of equities as you get closer to your target year.)

These wildly popular no-brainer funds help many people get into the game without having to learn much about investing. Last year’s pension act will only speed up that process by letting companies enroll workers directly in plans and choose a target-date fund as a default option.

This suggests investors may be investing more of their money automatically and not indulging in market timing, which would be progress in my book

One more sign of progress: individuals have tamped down their expectations of what they can earn from stocks.

“It’s clear that investors are more cautious, less exuberant now,” says Professor Meir Statman of Santa Clara University, one of the leading academic experts on individual investors’ behavior.

He cites a survey by UBS which asks individuals what annual rate of return they expect from their investments.

The median response was 12% in March 2000, at the peak of the dot.com boom. That fell to 5% in April 2003, just as the new bull market was getting started. In June 2007, he says, investors anticipated an annual return of 8%. That’s about halfway between the two extremes and in line with what financial planners tell their clients to expect.

This new realism has Wall Street pundits scratching their heads. They love to trot out the well-worn theory that you know the bull market is over when the “dumb money’ (i.e., individual investors) start gobbling up stocks.

By that logic, we’ve got a long way to go. Other things may signal the end is nigh—the near-collapse of two Bear Stearns hedge funds, the subprime-mortgage meltdown, and the new “repricing of risk

But if we’re at the top of this market, it’s not individual investors who are ringing the bell.

Comments? Please email us at TopProsTopPicks@InterShow.com.

Howard R. Gold is editor-in-chief of MoneyShow.com. The views he expresses here are his own and not necessarily those of InterShow.

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