Skeptical and scared, investors are checking their personal finances and pulling out of the market.

When nobody trusts the stock market, good sense flies out the window. Even a small financial crisis can throw the market into fits of unreasonable up and down swings. A large one, like the great panic of 2008, can throw the safest of investments under the bus.

Incoming SEC chairwoman Mary Schapiro says that, "investor trust is the lifeblood of our financial markets." Oh boy...does she have a challenge on her hands!

Irrational swings

Mutual funds are a great way for individual investors to diversify their personal finances. Managed by professionals for a reasonable fee, no-load funds gives you an easy way to ride the fluctuations of the stock and bond markets without investing much of your own time into research and trading decisions.

Exactly because mutual funds are so comfortable and useful, they also serve as great barometers of the market. When times are good, investors pour bucketloads of money into stock funds; when the economy goes south, that cash flows right back out. Due to the mutual fund's popularity, these moves have a profound effect on the stock market itself.

No safe harbor in this storm

Given these facts, it's no surprise to hear that mutual funds have seen lots of money flowing in and out of their coffers in recent months. One week in November 2008, Wall Street staged a bit of a rally, and investors put $10.4 billion more into mutual funds than they took out. But the next week, fortunes reversed once again, and $12 billion flowed out of the stock mutual fund industry.

Usually, when that happens, the money moves over to bond funds, because they're supposed to rise when stocks fall, and vice versa. Not this time, however. Bond funds mirrored the stock mutual funds exactly, just on a slightly smaller scale. These days, investors don't seem to trust either stock or bonds any further than they can throw them. It's almost as if they're suggesting that it's better to stuff that cash into your mattress, or maybe an FDIC-insured savings account.

Mutual fund choices

Fund managers are forced to roll with the punches. When you look at your personal finances, and then at the markets, and finally decide to get out of that good old index fund, its manager has to pay out your share. Usually, they have cash lying around for that purpose; but when sales happen too fast, they have to start selling stocks and bonds to keep up. This drives market prices down even further, pouring gasoline on the fire. Investors eventually come to their senses and start seeing deep values everywhere they look, which creates the opposite overreaction.

A patient investor can wait for the inevitable mega-drops, buy in, and then sit out the irrational swings for months or years. Short-term traders with too close an eye on the newswire and ticker tapes are bound to get burned.

Published on January 10, 2009