Do you have a mutual fund in your portfolio that isn't doing so well but you're not quite sure whether it's time to throw in the towel on it? We recently received a question from someone in this exact situation. While it may be tempting to dump your poor performers, here are some questions you may want to consider first:
Where does this fund fit into your overall asset allocation strategy?
Asset allocation, or how your money is divided between major asset classes like stocks, bonds, and cash, is the biggest factor in how your portfolio performs. The general idea is to have more money in conservative asset classes—like bonds and cash—the sooner you need the money and the more uncomfortable you are with risk. The longer you have until you need the money, and the more comfortable you are with risk, the more you can have in aggressive investments like stocks. If you're not sure what your asset allocation strategy should be, take a look at this worksheet for some guidelines based on your time frame and tolerance for risk. [More from Forbes: 10 bizarre investment strategies]
Let's say you're planning to use the money to buy a home in the next couple of years. In that case, you probably don't want to be taking risk so having that money invested in something relatively aggressive like an equity mutual fund wouldn't be appropriate no matter how well the fund was performing. After all, technology stocks were performing fantastically well right up until that bubble burst in 2000. We all know what happened to real estate starting in 2006 and financial stocks in 2008.
As you can tell, past and current performance isn't necessarily a good indicator of future performance (more on that later). Unfortunately, many investors didn't learn this lesson soon enough and bought into assets near their peak, only to sell them once they lost value and miss the recovery. We've all heard stories of people who bought real estate during the bubble, but it applies to stocks as well. A Fidelity study showed that investors who moved their money out of stocks in response to the financial crisis from October 1, 2008 to March 31, 2009, and then kept their money out of stocks through June 30, 2011, saw their average account balance grow by only 2%. Those who jumped back in at some point gained back an average of 25%, while those who stayed the course earned back an average of 64%.
Instead of following this "greed, hope, and fear" cycle, you want to examine how risky the investment is and whether it's appropriate for your goals and risk tolerance. Even if you're investing for a long-term goal and you're comfortable with the ups and downs of the market, you still have to think about how the fund complements what you already have. If the entire equity portion of your portfolio is in domestic stocks, an international fund could diversify it a lot more than another domestic fund would. Likewise, check to see that you have a balance of large-cap v. small-cap stocks, growth v. value stocks, and short-term v. long-term bonds. [More from Forbes: World's riskiest debt in pictures]
Keep in mind that just as every dog has his day, each of these asset classes will have their own cycles. Unfortunately, no one has figured out a way to reliably predict these cycles, but by spreading our money around we can try to make sure that we participate in whatever asset class is doing well at that time. As those funds appreciate in value they may exceed our asset allocation targets, and we'll need to re-balance our portfolio.
For example, if our target is 60% stocks (based on our time frame and risk tolerance) and the market is doing really well, our stock funds may grow to 75% of our overall portfolio. In that case, we'll need to move enough money out of those stock funds and into other areas to bring the percentage in stocks back to 60%. When stocks decline in value (as they inevitably will at some point), they may fall to 50% of our portfolio. We would then do the reverse and take money out of more conservative areas to bring the stock allocation back to 60%.
Rather than selling our losers as most people would do, we would actually be selling some of our winners to bring our portfolio in line with our goals. By doing this, we're forcing ourselves to buy low and sell high a little at a time. This approach helps to manage our risk and can even enhance our returns since today's winners can be tomorrow's losers and vice versa. That's why Warren Buffett is quoted as saying to be greedy when others are fearful and fearful when others are greedy. [More from Forbes: 10 financial planning moves for the big career shift]
How much is the fund costing you?
Once you know where a fund fits into your asset allocation, should you at least compare its performance to other funds in its asset class? Well, in fact, past performance is a pretty weak indicator of future performance. A recent study by Standard and Poor's showed that 12.23% of large-cap funds with a top-quartile ranking over the five years ending September 2006 maintained that ranking over the following five years. The numbers for mid- and small-cap funds were 3.08% and 20.22%, respectively. Random expectations were 25% so the previous winning funds actually had a lower chance of being a winning fund going forward than if you had picked a fund by throwing darts at a dartboard.
What's a better indicator of future performance? It turns out that funds with low fees and low turnover tend to have stronger future performance than funds with higher fees and turnover. Even the mutual fund rating service Morningstar had to admit that low fees were a better indicator of future performance than their own star rating system, which is based on past performance.
When it comes to mutual fund fees, people generally think of loads or the commissions that are charged to compensate brokers who sell you a load fund. But there are also annual fees that all funds charge to cover administrative, management, and marketing expenses. This expense ratio averaged about 0.79% last year. In addition, high turnover, or frequent buying and selling of individual securities, cause the funds to incur additional trading costs that were estimated to cost the average U.S. stock fund another 1.44%. That could be a total of over 2% a year of lost returns! [More from Forbes: 10 steps to get your retirement back on track]
The moral of this story is that you may want to dump your over-priced, high-turnover funds regardless of how well they've been performing for you. That performance may not last, but the costs will. Instead, consider funds with low cost and low turnover to implement your asset allocation strategy.
Could selling the fund save you some money in taxes?
Even if your fund fits into your asset allocation strategy and isn't costing you much, you may want to sell it anyway…at least temporarily. If it's in a taxable account and has lost value, selling it could allow you to use the loss to offset other taxes. If you don't have any capital gains to offset, you can deduct up to $3k of losses and carry the remainder forward to future years.
There are a couple of caveats to keep in mind though. One is that if you purchase the same or a similar investment within 30 days before or after you sell it, you can't write the loss off your taxes. But after that period, you can repurchase it and benefit from any future earnings. [More from Forbes: Highest state and local income taxes on a $1 million income]
The second caveat is that when you eventually sell the fund again, you could lose some of that tax benefit in the form of a higher capital gains tax. That's because you're now paying a tax on the growth from the lower price that you repurchased it rather than the higher price that you purchased it at the first time. However, the ordinary income tax rate you might be taking the deduction from now is likelier to be higher than the capital gains rate you might pay later, so you may still end up ahead. Also, if you never sell the fund, under current estate tax law you can pass it on to your heirs free of capital gains taxes.
As you can see, the decision whether to sell a fund involves a lot more than the fact that it doesn't seem to be doing well. In fact, that could even be a reason to add more money to it. Like most financial questions, it all depends on your situation.