Bond Fund Investors Learning Important Lesson The Hard Way

Over the past couple of years, many investors in bond mutual funds have gotten caught in a classic financial trap.

They stampeded into bond funds in 1993, when the market was strong, just in time to get clobbered in the great bond sell-off of 1994.

And in ‘94, with the market going into the tank, they scurried out of bond funds just in time to miss the great bond rally of 1995.

In that story, financial advisers say, lies a message about the difficulty of trying to succeed at investing by buying when a market looks attractive and selling when it looks bad.

All through 1993, investors poured money into bond funds at the rate of $9 billion to $12 billion a month, notes Bradlee Perry at the investment management firm of David L. Babson & Co. in Cambridge, Mass. This wave of enthusiasm continued into January 1994, when they made net purchases of $11.1 billion.

By then, however, a long decline in interest rates, and accompanying rise in bond prices and bond fund net asset values, had begun to reverse itself. Bond rates, which had turned upward in late ‘93, took off as the Federal Reserve began a year-long campaign of tightening credit conditions.

From March 1994 through January of this year, bond funds had 11 straight months of net outflows. The red ink crested at $10.9 billion last November, the very month when the bond market was hitting bottom.

“Most likely,” Perry observes, “a number of those who sold at the lows said to themselves ‘never again - I don’t ever want to own another bond.’ Unfortunately, just when that attitude became pervasive, bonds were at their most attractive valuation levels in many years.

“Now that the bond market has staged a strong recovery,” Perry adds, “individuals have stopped retreating from bond funds, again reacting to events much too late.”

In cautionary tales like this, many observers have traditionally seen evidence that the small investor just isn’t very smart. But a lack of intelligence may not be the problem at all.

Last year, there were many thoughtful reasons to dislike bonds - among them the fact that they had just completed a multiyear rally that had taken interest rates, and thus bond yields, to their lowest levels in a generation.

Many of the most sophisticated professional investors were shunning bonds too. Indeed, you had to be a little reckless to be buying bonds at this time about a year ago.

The trouble is, what a reasonable, intelligent investor can conclude by thinking about the markets is usually already reflected in the markets.

So if you want to succeed at timing an investment like bonds, you have to have an approach that allows you to buy when they look truly undesirable, and sell when they seem the ideal thing to own.

One way to get around this difficulty is a buy-and-hold approach to investing that ignores economic and market fluctuations.

“Long-term holders of bonds purchased before 1993 have done well with them,” Perry observes. “Even buying bonds near their 1993 highs was not a bad mistake for patient investors who hung on and rode through the big decline.

“However, selling at 1994’s low prices was a big mistake for those who panicked.”

As the experience of last year shows, buy-and-hold investing can take a lot of discipline. Alternatively, you can try to time the markets using some system or philosophy that you hope will override the pull of emotion and conventional thinking, and thus enable you to buy low and sell high.

Many people attempt to do this, whether they think of themselves as market-timers or not. Some claim success, or at least believe that the risks of market-timing endeavors are justified by the rewards that can be gained.

But the evidence of data like the 1993-94 flows of money into and out of bond funds certainly is chastening. It strongly suggests that when they try to time the markets, the majority of investors don’t succeed.