Amid Waves of Panic, a Sea of Calm

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Meet Nancy Stein.

Nancy is a retired real estate agent from Illinois, and she's had it with the stock market. Unnerved by market volatility, she sold almost all of her investments earlier this year. "I felt the people buying were people inside the market. They weren't the investors of the past who wanted to protect what they had or see it grow a little bit," she toldThe Wall Street Journal, which interviewed her for a story on investors cashing out of stocks. "Across the country, investors are fleeing the stock market for the safety of cash," it wrote.

Now meet Fritz Dixon.

Fritz is a former physician from Idaho. He, too, was interviewed by The Wall Street Journal for a separate story on investors fed up after this summer's rout. Dixon has dumped all of his stocks and says the odds are "zero" that he will ever own them again. The volatility is too much. "You can shear a sheep many times, but you can only skin him once. And I ain't gonna lose any more skin," he said.

The Journal isn't alone in profiling the plight -- and flight -- of small investors. Several media outlets have highlighted stories of investors abandoning stocks and swearing them off for good. The stories are usually backed up by scary statistics. "Investors flee stock funds at rate not seen since 2008 panic," USA Today wrote in August. Investors pulled nearly $24 billion out of mutual funds, it pointed out -- "the biggest weekly outflow since Oct. 15, 2008."

You can probably relate to these investors' frustrations. Market volatility became so erratic this summer that it often felt like a rigged game. July and August were two of the most volatile months in the modern history of our stock market, with the Dow Jones Industrial Average (INDEX: ^DJI) finishing either up or down more than 2% on nine occasions. If everyone else is fleeing, do they know something you don't? Should you be cashing out, too? Those are questions investors have undoubtedly asked themselves this year.

But take heart. Dig through the details and this story isn't nearly as frightening as it looks on the surface. As a whole, individual investors are not fleeing the stock market, and there's no reason you should be, either.

Journalists use techniques like the anecdotal lede to transform relatable personal stories into broad trends. But in a market with tens of millions of investors, what Nancy Stein or Fritz Dixon do with their investments is irrelevant. You have to look at the broad numbers to accurately gauge what's going on. And even then, you have to look at the right numbers and put them in the right context.

When attempting to show that investors are fleeing the market, you'll likely see data from the Investment Company Institute showing money flows into and out of mutual funds. So far in 2011, retail investors have pulled $50 billion out of stock-based mutual funds, which might appear like an exodus.

But mutual funds are just one slice of the investment world -- and they're a dying slice at that. Focusing on mutual funds alone ignores one of the biggest trends in modern finance: Over the past decade, mutual funds have been replaced by exchange-traded funds, or ETFs, which are far more convenient to trade and typically come with lower management fees than traditional mutual funds.

And guess what? While investors have been pulling money out of stock-based mutual funds, they've been adding money to stock-based ETFs. Year to date, retail investors have added about $20 billion in net cash to stock-based ETFs, according to National Stock Exchange. Add that to the $50 billion pulled out of mutual funds, and net stock outflows this year total about $30 billion. Consider that U.S. households and nonprofits hold more than $14 trillion of stock assets, and that's barely a rounding error -- a fraction of 1%.

Here's another figure that might come as a surprise to those proclaiming the death of the individual investor: In 2006, when the economy and markets were booming, U.S. households and nonprofits held $13.8 trillion of stock assets. Earlier this year, when investors were supposedly fleeing markets, the total stood at more than $14 trillion.

Indeed, when we checked in with some of the largest brokerage houses in the country to gauge how investors reacted to this summer's volatility, we got the same answer again and again: with remarkable calm.

At the Vanguard Group, 98% of investors didn't make a single change to their retirement portfolios in August, when market volatility peaked. "Ninety-eight percent took the long-term view," wrote Steve Utkus, who oversees the Vanguard Center for Retirement Research. "Those trading are a very small subset of investors."

Even during longer periods when markets underwent gut-wrenching drops, the percentage of Vanguard investors who called it quits was incredibly small. "We know from our research that during a financial crisis, few investors actually cash out their entire portfolios," Utkus wrote. "Yes, there is always a small fraction of investors -- 3% in the recent financial crisis -- who sell everything, so there's always someone to interview about getting out of the market. But they aren't typical investors." A Nancy Stein or a Fritz Dixon can always be profiled, but they simply don't reflect broader investor trends.

We found an even more bullish sentiment at TD AMERITRADE (NAS: AMTD) . Over the week of August 8, as markets plunged, "retail clients were slight net buyers of securities," a spokesperson said. That's not to say they weren't paying close attention. Account logins on Aug. 5 and Aug. 8 -- immediately preceding and following the U.S. credit rating downgrade and market volatility that ensued -- were up 23% from "typical volume." What's more, while the Dow was on its way to dropping 635 points on August 8, call-center volumes were up 72% versus the company forecast. Yet, again, TD AMERITRADE's retail investor clientele were net buyers of the dip.

Scottrade had a similar storyline. "Overall, investors are confident and engaged. In September, Scottrade's buy/sell ratio consistently favored the buy side," said a company spokesperson. To boot, "about 60% of investors plan to keep their investments at the same level and about one-third ... are planning to invest additional money." Rival E*TRADE (NAS: ETFC) added a net 116,000 new brokerage accounts in the year ended Sept. 30, including 13,000 in the most recent quarter.

There is, it seems, a disconnect between anecdotal evidence and actual evidence. Vanguard's Utkus summed it up nicely: "When markets are falling, trading activity jumps, sometimes by large amounts. And we are somehow misled into believing that 'everyone' is dumping stocks and getting out of the market. But overall ... most investors have a long-term perspective and don't react to falling markets."

This is encouraging. As Ben Graham, Warren Buffett's early mentor, used to say, "In the short term, stocks are a voting machine, and in the long term, stocks are a weighing machine." Volatility is just that -- temporary ups and downs, not long-term structural fractures that should derail your goals. Graham's wisdom is as true today as it's ever been. And thankfully, it's a lesson that individual investors don't appear to have forgotten.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

At the time this article was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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