Asset Allocation of Mutual Fund Investors

This paper studies mutual fund investors' asset allocation decisions using monthly flow data of U.S mutual fund industry from 1984 to 1998. We find that mutual fund investors change their asset allocations between stocks and bonds in reaction to business conditions tracked by changes in expected stock market returns. They tend to allocate less into stock funds during the trough of a business cycle when expected stock market returns are higher and to allocate more into stock funds during the peak of a business cycle when expected returns are lower. We also find that variables that capture the changes of real macroeconomic activities have strong impact on mutual fund investors' asset allocations between stocks and bonds. During expansions of the economy, they tend to invest more into stock funds than into bond funds. During recessions of the economy, they tend to invest less into stock funds. Mutual fund investors' economic trend chasing behavior and their negative reaction to changes in the future expected stock market returns provide some evidence that they are irrational and could play a destabilizing role in the financial markets.