Chasing returns…don’t get crazy!

john-lennon-fans-sized.jpg (JPEG Image, 616 × 479 pixels)Chasing Returns

Decades of behavioral research suggest investors chase returns. In other words, they sell one investment to buy another that has performed better on the hope that it will continue to do so. Although this behavior is known to be very common, exactly which returns investors chase is less discussed. Do they chase returns over a month? A year? Three years? Five years?

For the U.S. stock market, it appears the rolling five-year has been the return that investors have most closely followed based upon their investing behavior in recent years. The five-year trailing annualized return for the S&P 500 has been weak, especially when compared with bonds, in recent years.

In fact, even as recently as the end of August 2013, the difference in the five-year annualized return between stocks and bonds was only about 2%, hardly enough to compensate investors for the volatility they experienced. Yet that difference has started to soar and may lead to investors chasing returns into the stock market.

In the past few weeks, the five-year return has soared into the double digits – reflecting not only a strong recent trend in the stock market, but the dropping off of much of the horrific declines in the fall of 2008, when the financial crisis took hold. The gap between stock and bond market returns over the past five years as of the end of last week widened to 10%. As of March 6, 2014, five years from the bear market low in the S&P 500 – even assuming no additional gains in the stock market between now and then – the five-year annualized return may have exceeded bonds by 20%!

The one-, three-, and five-year trailing annualized returns are now in the double digits for the first time this cycle. This may prompt many investors to reconsider the role of stocks in their portfolios – especially as interest rates rise and bond performance lags.

In fact, a great rotation back to stocks may already be underway. Net inflows have been positive into bond funds over the past five years, while funds that invest in U.S. stocks saw net outflows, according to ICI data. But the month of October 2013 saw the biggest monthly inflows to funds that invest in U.S. stocks in years (excluding January’s seasonal peak for inflows) – despite the concerns over the government shutdown and debt ceiling. It is no surprise that this took place just as the five-year trailing return for stocks began to soar into double digits.

Although corporations will likely remain buyers of their stocks in the coming year, 2014 may finally be the year that individual investors as a group begin to buy stocks in contrast to the net selling they have done since the bull market began nearly five years ago. This may help to continue the rise in the valuations that defined this year’s outstanding gains for stocks.

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