Invest in stocks? Small players still smarting

NEW YORK -- On Main Street these days, investing in the stock market is about as popular as watching a scary movie on a 12-inch black-and-white TV.

Wall Street's long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors. Playing the market isn't as sexy as it used to be. Since the 2008-09 financial crisis, the buy-now mentality has been replaced by a get-me-out, wait-and-see, bonds-are-safer line of thinking.

Stocks remain out of fashion even though the stock market has risen more than 100% since the bear market ended three years ago. It's up 25% since October and 9% this year.

Retail investors have yanked more than $260 billion out of mutual funds that invest in U.S. stocks since the end of 2008, says the Investment Company Institute, a fund trade group. In contrast, they have funneled more than $800 billion into funds that invest in less-volatile bonds.

Michael Hoffman, a 66-year-old psychotherapist from Dana Point, Calif., has none of his money tied up in stocks. "I'm never going back in," he says.

Bart Ruff, 48, a brand manager from Lederach, Pa., isn't putting any new money into the market. "The roller coaster of the last five years," he says, "has made me more conservative."

Arlene Armstrong, a 61-year-old fundraiser from Columbus, Ohio, and her husband, Mike, 62, have slashed the share of stocks in their portfolio to 14% from 60%. "We are considering buying more stocks, but we're still recovering from the trauma we experienced when the market tanked," she says.

What made small investors like the Armstrongs so leery of stocks was the most severe market decline since the Great Depression. They remain on the defensive even though U.S. stocks have doubled since March 2009 and a Who's Who of finance — including billionaire Warren Buffett— insist stocks are a better investment now than cash, bonds, gold and other assets perceived as safer.

Investors' chronic mistrust of stocks is reigniting fears that an entire generation is unlikely to stash large chunks of cash in the increasingly unpredictable market as they did in the past.

"Investors have suffered a traumatic shock that has caused severe psychological damage and made them more risk-averse," says Carmine Grigoli, chief investment strategist at Mizuho Securities USA. Current worries, such as the USA's swelling deficit, Europe's unresolved debt crisis and slowing growth in China, have done little to ease their anxiety, he adds.

Evidence of a decrease in risk-taking is borne out in buying patterns of the nation's 90 million mutual fund investors. Mutual funds are the main investment vehicle used by individuals to save for long-term needs such as retirement and college. Main Street investors have continued to withdraw money from U.S. stock funds for 10 straight weeks, totaling an estimated net outflow of $29.4 billion, ICI data show.

A "bunker mentality" pervades the psyche of many investors burned by not only the 2008 financial crisis, but also the 2000 technology stock bust, says Mark Luschini, chief investment strategist at Janney Montgomery Scott.

"The scar tissue is still so fresh," says Luschini. "If individual investors are not pulling out of stocks outright, they continue to reduce risk by lightening up."

Hoffman is content to stay on the sidelines. Fearing another financial shock and market dive he cannot afford as he nears retirement, he fled the market.

"I am out of stocks completely," says Hoffman, who reinvested the money in assets he perceives as less risky. Sixty percent is now in bonds. Thirty-five percent is invested in pre-1932 Saint Gaudens gold coins. The rest is in cash.

Hoffman has plenty of company when it comes to reducing exposure to stocks. The percentage of U.S. households that own individual stocks or stock mutual funds dropped to 46.4% last year, down 13 percentage points since 2001, ICI data show.

And while younger investors with longer time horizons continue to hold hefty weightings of stocks in their 401(k)s, investors in their 40s, 50s and 60s have cut their holdings. Fifty-one percent of people in their 50s had more than 80% of their money invested in stocks in 2000. At the end of 2010, only 25.5% had such stock-heavy portfolios.

Mike and Arlene Armstrong are part of the growing army of investors who have sold stocks to cut risk.

"We panicked several years ago when the market tanked and our stocks were worth one-third less," says Arlene. "With some knuckle-biting, we stayed the course. When our stocks regained their value this past year, we sold most of them and put the funds into less-risky investments. We were relieved to have our money back."

Touting the stock market

Individual investors have been net sellers of stock funds during a period in which the stock market has soared. The Standard & Poor's 500-stock index is up 102.4% since it hit bottom in March 2009. The broader Wilshire 5000 index is up 109.6%, or $9 trillion.

In the past few months, a handful of Wall Street's most influential players have also come out and said that given a choice between buying stocks or bonds, stocks are the way to go:

•In February, Buffett said that over an extended period, stocks — not bonds or gold — will be the "runaway winner."

•Around the same time, Larry Fink, CEO of BlackRock, the nation's largest money-management firm, with more than $3.5 trillion under management, told Bloomberg News that investors should be 100% invested in stocks. A yield of roughly 2% on the 10-year Treasury bond is too paltry. Compared with bonds, while stocks are more attractively priced and offer better upside, he argued.

•Goldman Sachs made a similar call in late March, arguing that "the prospects for future returns in stocks relative to bonds are as good as they have been in a generation."

So far, individual investors are mostly ignoring the advice.

"They are stuck on the sidelines and won't come back in any time soon," says Woody Dorsey, founder of Market Semiotics, a firm that specializes in investor psychology.

Stuck in the recent past

So what's scaring investors?

Their emotions are getting in the way, says Denise Shull, author of Market Mind Games: A Radical Psychology of Investing, Trading and Risk.

Many investors are suffering from a behavioral finance concept known as "recency bias" — they fear another market crash.

"People are not taught to analyze their emotions," explains Shull. "And without asking what I am feeling and why, they never get to disentangle emotion from their decision-making. … They are not getting in because of anxiety. A reduction of anxiety and fear would help."

Changing demographics are also playing a role in investors' shift to less-risky investments, says Brian Reid, the ICI's chief economist. As Baby Boomers age and enter or near retirement, the need for income and capital preservation increases, reducing the need for a heavy weighting of stocks.

There's no shortage of uncertainties, either.

Dorsey says investors are worried about the presidential election in November, unaddressed solutions to the nation's fiscal troubles and potential changes to the tax code.

Periodic scares coming out of Europe, such as poor readings on the health of eurozone economies, political upheaval and sharp surges in the yields on European government bonds — which spark fresh concerns about another financial crisis — do little to bolster confidence.

When it comes to jumping back into the market after steep declines, individual investors historically have not been "early adopters," says Tobias Levkovich, chief U.S. equity strategist at Citigroup. They typically don't move back into stocks until the market has moved up sharply and they think it's safe to get back in.

Yet investors have lived through so many wild swings recently that they worry that "just when they think it is safe to dip their toes back in the water, the shark shows up again," Levkovich adds.

Walter Zimmermann, analyst at United-ICAP, says these Chicken Littles might actually be behaving rationally.

"Our work suggests that caution is warranted here — not boldness," he says. "We view those on the sidelines as making the prudent choice."

Despite investors' caution, their level of fear is much lower than it was during last summer's stock swoon or at the height of the financial crisis. A closely followed Wall Street fear gauge closed around 19 on Monday, below the 48 it hit last August and well below the peak reading of around 80 in October 2008. In general, a reading below 20 suggests investors are calm and not fearful.

What's needed

So will investors ever rekindle their love affair with stocks? If so, what will bring them back?

"Some investors may be waiting for sanity to come back into the markets," says Axel Merk, chief investment officer at Merk Investments.

Restoring investor confidence in the U.S. economy and job and housing markets will go a long way toward making investors feel secure and ready to take more risk, says Gina Martin Adams, institutional equity strategist at Wells Fargo Securities. "A broad spectrum of economic data has an impact on investors' risk tolerance," she says.

Don Luskin, chief investment officer at Trend Macrolytics, takes a more cynical view of investors' likely behavior.

"It is in the nature of things that they won't come back in until they shouldn't," he says. "They don't understand that there can be no superior returns without risk. They will come in when they think there is no risk, at which point there will be no return."

James Paulsen, chief investment strategist at Wells Capital Management, says investors are likely to gravitate back to stocks if the S&P 500 climbs another 14.3% and gets back to its 2007 all-time high of 1565.

Stocks will also appear more attractive when bond yields start to rise, causing bond prices to fall and principal losses for investors. "Stories that highlight how much investors invested in steady-eddy, safe havens underperformed relative to stocks" will push them back into stocks, Paulsen says.

Maybe. Maybe not.

Arlene Armstrong says she will hide out in money market funds for now but will consider buying stocks again when "the market dips."

Ruff, who trimmed his stock exposure to 45% from 65%, says he won't be a big buyer of stocks until the market suffers another sizable swoon like 2009.

Hoffman, however, says that because of his age and with retirement approaching, it's unlikely he will ever venture back into the stock market again.

"I am done," he says.