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? While it may be tempting to dump your poor performers, it’s important to know when to hold ‘em and when to fold ‘em so 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. Conversely, 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.
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 a lot of 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.
Instead of chasing past performance, 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. For example, 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 vs. small-cap stocks, growth vs. value stocks, and short-term vs. long-term bonds.
Keep in mind that just as every dog has his day, each of these asset classes will have its own cycles. Unfortunately, no one has figured out a way to reliably predict these cycles, but by spreading your money around, you can try to make sure that you participate in whatever asset class is doing well at that time. As those funds appreciate in value, they may exceed your asset allocation targets, and you’ll need to re-balance your portfolio.
For example, if your target is 60% stocks (based on your time frame and risk tolerance) and the market is doing really well, your stock funds may grow to 70% of your overall portfolio. In that case, you’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 (like they have recently), they may fall to 50% of your portfolio. You would then do the reverse and take money out of more conservative areas to bring yourself back to that 60% target.
Rather than selling your losers as most people would do, you would actually be selling some of your winners to bring your portfolio in line with your goals. By doing this, you’re forcing yourself to buy low and sell high a little at a time. This approach helps to manage your risk and can even enhance your returns since today’s winners can be tomorrow’s losers and vice versa. That’s why Warren Buffett was quoted as saying to be greedy when others are fearful and fearful when others are greedy.
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 long-term performance even when comparing similar funds to each other. One study found an inverse relationship between the length of time and the ability of top-performing funds to maintain their success.
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. 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. However, there are also annual fees of typically around 1% called the “expense ratio” that practically all funds charge to cover administrative, management, and marketing expenses. Morningstar
In addition, high turnover, or frequent buying and selling of individual securities, cause the funds to incur additional trading costs. These were estimated to cost the average U.S. stock fund another 1.44%. That could be a total of almost 2.5% a year of lost returns from fund expenses and trading costs!
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 likely 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. This is called the “wash sale” rule. But after that period, you can repurchase it and benefit from any future earnings.
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 will probably still end up ahead. Also, if you never sell the fund, 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 performing well right now. In fact, that could even be a reason to add more money to it. Like most financial questions, it all depends on your situation. If you’re not sure whether to hold or fold a fund, you may want to speak with an unbiased financial planner. Your employer may even offer you access to one for free through a workplace financial wellness program.