The Impact of Risk and Return Perceptions on the Portfolio Reallocation Decisions of Mutual Fund Investors

Abstract

To explore how portfolio allocations among equities, fixed income securities, and cash are impacted by investors’ risk and return expectations, this paper explores portfolio reallocations among equity, bond, and money market mutual funds. As predicted by the literature on optimal portfolio allocations for hypothetical investors, mutual fund investors rebalance in response to variables which have been found to have possible predictive content for future stock market returns and/or volatility, especially the slope of the term structure. We also find that investors’ portfolio reallocation decisions are strongly correlated with recent stock and bond market returns and stock and bond market uncertainty as measured by implied volatilities. Stock market returns primarily stimulate exchanges between equity and money market funds with little impact on bond funds. Similarly bond market returns primarily stimulate exchanges between bond and money market funds with little impact on stock funds. Mutual fund investors apparently pay more attention to bond market returns than to current yields-to-maturity. Increases in stock market uncertainty lead to a movement of funds out of equity funds while increases in bond market uncertainty lead to exchanges out of bond funds. We find no evidence that mutual fund investors follow the advice of financial advisors to rebalance following large stock or bond price movements to restore their portfolio proportions to pre-existing target levels. Instead they do the opposite moving more funds into equity funds when the stock market rises and into bond funds when the bond market rises.