Financial losses have a much greater impact on investor psyche than do equivalent gains.

Studies report that the pain of losing money is two times greater than the elation of winning an equal amount.

As well, the memory of loss appears to be longer lasting than the memory of recent wins. Investors pulled money from equity funds and generally bought fixed income products, even during strong equity performance periods such as 2003 and 2009, two plus-side tail events following market downturns that many investors missed because they were too busy licking their wounds and climbing a wall of worry propagated by the mainstream media.

As one can see in the tables on estimated net flows, from 2008 to 2011, U.S. investors pulled money from domestic equity funds while padding the coffers of mixed-asset funds and taxable bond funds. A few investors became slightly less risk averse and tiptoed back into equity securities via the funds in Lipper's Sector Equity Funds and World Equity Funds macro-groups, with Commodities General Funds and Emerging Markets Funds being the primary beneficiary classifications.

Perhaps it is just a matter of demographics at work, but we have seen a strong trend in mutual fund flows that suggests investors have begun earnestly diversifying their portfolios toward fixed income products, in many cases away from equity funds. Over the last three years mutual fund investors have injected $4.87 into fixed income funds for every $1.00 injected into equity funds-definitely a significant change in investment trend from, say ten years ago. For the three-year period following the 2002 market rout, equity funds attracted $14.96 for every $1.00 injected into fixed income funds.

Digging a little deeper into equity fund flows, we see a new trend emerging. Whether created by defined contribution plan defaults or by investment design, investors appear to be embracing the one-stop benefits of investing in target-date and target-risk funds (Mixed-Asset Funds). These types of funds attracted some $220 billion during the three-year period ended Dec. 31, 2011, ultimately leaving the remainder of the equity funds group in net-redemption territory to the tune of about $82 billion for the same period. An old staple of most U.S. investors' portfolios, domestic equity funds (aka U.S. Diversified Equity Funds) have experienced a startling decline in net new purchases. USDE Funds' estimated net flows have shown an exodus of approximately $211.5 billion during the last three years, despite the macro-group's posting the second strongest three-year average annualized return (+14.12%) for the period of Lipper's four equity macro-groups-outpaced only by Sector Equity Funds (+14.82%).

Many pundits think the pendulum has swung too far. The two downside-tail events that occurred in 2002 and 2008 appear to have severely influenced investor behavior. After watching equity portfolio values decline 39.28% on average in 2008, many investors threw in the towel and perpetrated the wealth-destroying cycle of buying high and selling low (see the 2008 equity flows table).

However, if we look at the distribution pattern of returns over the last 10 years, we see the historical pattern of three down years and seven up years still holds. While the average equity fund return for the 10-year period (+4.42%) lags the 87-year average of 8.42%, investors who stayed out of the equity markets missed some very strong returns and probably are still in the red.

The recent events show us that, with a long enough investment horizon, a well-diversified portfolio, and a regular rebalancing plan, even extreme tail events can be mitigated. After the 2002 and 2008 market meltdowns (both negative tail events) each follow-on year was a tail event in the opposite direction, with equity funds returning 35.93% in 2003 and 34.58% in 2009. The plus-side returns were not enough to completely make up for the prior year's loss, but they certainly made the hole less deep!

While we cheer what appears to be a new trend of investors diversifying parts of their portfolio to different asset classes (fixed income, commodities, world securities, REITs, and hedge-like funds), we believe the memories of recent losses are keeping many investors out of the equity markets. Perhaps they are following the old adage, "fool me once, shame on you: fool me twice, shame on me."

However, in this fickle market that has seen a decline in the U.S.'s sovereign credit rating but also a rise in U.S. Treasury prices, we should keep in mind the other old adage, "don't put all your eggs in one basket." If you are waiting for the perfect time to reenter the equity market, you'll probably wait until it's too late in the market cycle. Remember, often it is much more beneficial in the wealth creation process to go against the grain and do what is uncomfortable.

Over the last 87 years the number of years of equity outperformance (63) handily beat the number of years of underperformance (24). Armed with this knowledge, we shouldn't let the fear of loss alone drive our investment decisions. Instead, we should take comfort during tough times by sticking to our asset allocation strategy, supplemented by a regular periodic rebalancing-forcing us to buy low and sell high, just at the time we might rather do the opposite.


Tom Roseen, is a senior analyst with Lipper.
He is the editor and an author of Lipper's U.S. Research Studies,
Fundflows Insight Reports and Fund Industry Insight Reports.