The second, larger issue relates to the long-term structural problems, which have been largely unaddressed thus far. Europe is home to a variety of economies, each with its own set of challenges, whether a housing market bubble, an over-leveraged banking sector, or a workforce struggling to remain competitive. These economies no longer have as broad a set of policy tools to address their challenges, either through devaluing their currency or adapting monetary policy tailored to their particular circumstances. As it stands, the European Central Bank can only set a single policy for this diverse group of economies despite their different dynamics and different needs. Until that fundamental problem is addressed, we believe investors will likely continue to see waves of volatility from the European bond markets.

Read more in our quarterly Q&A.

This common response to uncertainty is demonstrated clearly in DALBAR’s 2012 Quantitative Analysis of Investor Behavior. In the study, DALBAR found that while the Standard & Poor’s 500 Index gained 2.12% in 2011, the average stock fund investor lost more than twice that amount.

The reason for the underperformance, according to the study, is that equity investors were driven by last year’s volatility to cash out of their holdings. “This fear-driven activity took place primarily after down swings and led investors into cash that offered virtually no return.” (DALBAR) Last year’s markets continued a trend of higher volatility that began with the financial crisis. In fact, daily price changes in the S&P 500 Index over the past five years have been significantly more volatile than in the years leading up to the crisis.

DALBAR’s data reflect a persistent theme in investor behavior that behavioral scientists note can derail even the best client planning: selling off investments in response to negative macroeconomic news and market volatility. The firm’s research shows that over the past 20 years, on average, investors have held stock funds for only 3.29 years and fixed-income funds for only 3.09 years before selling — too short a time to reap longer-term market performance.

Of course, many of the macro risks that drove volatility in 2011 remain, and the economy has not escaped the secular pressures brought on by the still-deflating global debt bubble. Investors and advisors may look to the higher holding period of asset allocation investors when considering how to address the adverse effects of volatility, recognizing that investments designed to lower volatility or mitigate its impact on returns may help investors hang on longer.

* Average stock investor performance is calculated by DALBAR using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions, and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses, and any other costs, After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions, and exchanges for each period.

A large segment of the survey’s respondents — 30% — also described the European debt crisis as the topic most likely to influence markets this year.

In addition, 98% of advisors agreed that actively managed funds should play a role in client portfolios to help investors meet the twin challenges of mitigating risk and finding returns.

A total of 195 advisors, from a range of distribution channels, participated in the online survey between December 2011 and January 2012. Responses to the volatility and active management questions are below.

For Putnam’s views regarding both market volatility and active return opportunities, read Capital Markets Outlook.

Over the long term, the reason high-yield bonds offer a spread advantage is to compensate investors for the risk of default. Historically, that par-weighted default rate has been 4.2%. However, today the market has a par-weighted default rate of 1.9%, which is well below the long-term average, and we believe that trend is likely to continue over the near term.

Looking back at historical default patterns in high-yield investing, there have tended to be rather prolonged periods of below-average defaults following a spike in the default rate. The last signifi­cant peak occurred in November 2009, when defaults exceeded 13%.

Many of today’s businesses that survived the crisis are running very lean organizations, with strong balance sheets and historically large levels of cash on hand. In the current economic environment — which represents a significant improvement from the depths of the recession and financial crisis in 2008 and 2009 — we believe that the companies within the high-yield universe should be able to continue to grow their businesses and that the default rate, as a result, ought to remain low.

Today, in our view investors are being paid more than usual in the form of higher yields for assuming below-average default risk.

Read our perspective on second-quarter fixed-income opportunities and risks below or download as a pdf.

Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk.

In Spain, first-quarter results were negative even as markets around the world generally advanced by double-digit amounts.

Disconnected market performance like this rarely occurs without a fundamental cause. Investors may be detecting growing strains in Spain.

While we are comfortable with maintaining a pro-risk stance overall as the second quarter begins, signs of stress from the stock markets or from credit default swaps (CDS) of Spain, Italy, Portugal, or Austria would prompt us to reduce risk levels.

Read our perspective on second-quarter opportunities and risks below or download as pdf.