Investors are dumping stock funds and buying bond funds at record rates according to the Investment Companies Institute an alarming trend to professionals who watch market psychology.

“If you’re moving toward psychological comfort, you’re making a mistake,” said Don Cassidy, a senior analyst at Lipper Inc. and author of “Trading on Volume.” “You can watch crowd behavior and tell when the market is about to change direction.”

Record outflow from bond funds in December 1994 marked the month that the bond market bottomed out in its worst year in modern times. Record inflows to stock funds in early 2000 presaged the tech wreck and the start of the bear market.

The timing looks just as bad today to Urbin McKeever, a bond specialist at Frost Investment Services in Fort Worth, Tex. Investors pulled $52.6 billion out of stock funds in July and socked $28.1 billion in bond funds, according to the ICI. Investors have put $86.6 billion in bond funds through July.

“Here you have people coming out of stocks at their lowest point in six years and going into bonds at their highest point in 40 years,” said McKeever, a senior vice president at Frost. “We’ve been able to talk our clients out of it.”

Playing the game

Institutional investors are doing just the opposite, as they apply an investing formula called an asset allocation. To maintain a 60/40 ratio of stocks and bonds after a sharp decline in stock prices, they’re selling bonds and buying stocks. Applying a formula requires them to sell high and buy low.

“If you don’t rebalance, the market will do it for you,” said David Goerz, chief investment officer of mPower.com, which provides advice to 1.2 million retirement savers. “Asset allocation is 90 percent of the game.”

Most investment-oriented Web sites offer asset allocation calculators.

Don’t wait if your investment mix is out of whack. Bonds are a safer bet for investors who are nearing goals like retirement, or who have a small appetite for risk. Because the bond market keys on interest rates rather than profits, bonds usually move in the opposite direction of stocks.

The Lehman Bros. Aggregate Bond index gained 9 percent a year during the past three years, according to Thomson Financial data through July. In the same period, the Standard & Poor’s 500 lost 10.8 percent a year.

Make move carefully

But move cautiously if the remedy means buying bonds now. Today’s record-low interest rates translate to record high prices for bonds. Because prices move in the opposite direction of interest rates, bonds will depreciate in value when rates start back up.

Step 1 is to forget about historical performance, says John Hollyer, a bond manager at the Vanguard Group. Bond funds have been booking gains as prices climbed in recent years, he says. Those gains aren’t likely to continue with interest rates where they are. At some point, they could turn into losses.

“With bonds, you’re buying current yield,” Hollyer said. “You’re buying an income stream. The higher the yield, the more you should like it.”

Time is another factor in choosing funds. The longer the average maturity of the bonds in its portfolio, the more vulnerable the fund is to rising interest rates because the manager must wait longer to reinvest at higher rates.

The rest is a guessing game. A fund that expects to replace its average bond in five years might pay a current yield slightly higher than 5 percent, or about 4 percentage points more than a money-market fund, Hollyer said. If the differential lingers, the bond fund is the right choice.

“I would go with shorter maturities,” said Bryon Green, president of Green Investment Management in Fort Worth. Green recommends funds with two-year to five-year time horizons. The funds would describe themselves as short-term or intermediate-term funds.

Quality is the final factor in choosing bond funds. Corporate and mortgage bond funds feature higher yields than government bond funds because there’s more risk of default of investors not getting the principal back.

Long-term is bad choice

Investors pay a premium for the safety of government bonds in bad markets. In timing terms, buying long-term, government bond funds would be a bad choice today.

Corporate bond funds aren’t particularly tame, either. Credit quality issues rattled the bond industry in July. Corporate bond prices plummeted and current yield soared as investors weighed the probability of bankruptcy filings. Prices recovered in August, but the risk of default remains.

Avoid bond funds that push the envelope on credit quality. Aggressive funds like Alliance Corporate, Invesco Select Income and Strong Corporate shone in great bond years like 1995, but Morningstar reports that they lost 11.6 percent, 10.3 percent and 8.9 percent respectively in the 12 months ended July 31.

But even the worst bond fund looks good next to the swoon in the S&P 500.

Investors are noticing, says Fort Worth financial planner Guy Cumbie, who chairs the national Financial Planners Assn.

“I met with (a potential client) yesterday,” Cumbie said. “He was 100 percent equity and not liking it.”

With the rush on to bond funds, he said, “let’s hope it’s short-term bond funds.”