Should You Sell?

Quick show of hands: How many of you have actually made money in the stock market this year? Me neither.

It's very tempting to start looking askance at the underperforming funds in my portfolio, and ask whether it still make sense to own them. But a recent study from Baird Advisory Research Services reminded me why I should hang on.

It's not as bad as it looks
Baird found that even the best mutual fund managers encounter periods of underperformance. They studied 505 funds that had outperformed their benchmarks by 1% annually over a 10-year period. During those 10 years, 81% of these managers had at least one three-year period of underperforming their benchmark by 1% or more, while 31% had underperformed by 5% during a three-year period.

In other words, even the best long-term managers have periods of short-term underperformance. And even more importantly, short-term underperformance didn't prevent them from producing excellent long-term results.

The lesson behind these numbers is clear -- don't give up on good, talented managers just because they're having a rough spell. 

Look at the big picture
So how do you know if the manager running your mutual fund is someone to stand behind when performance lags?

At Motley Fool Champion Funds, the investment service I advise, we have three rules of thumb for good managers:

  • Tenure. Invest with managers who have been investing for years, if not decades, not managers who are still learning on the job. Make sure they've been on the job in both bull markets and bear markets.
  • Performance. Has the manager outperformed the market over the long haul? Any manager can have a year or two of outperformance, but consistent outperformance is something worth noting.
  • Consistency. Has the fund been using the same investment philosophy throughout its history, in both good and bad environments, or does it change its stripes to fit the latest investing fad? You want a manager who sticks to his or her guns no matter what, not someone who tries to be all things to all investors.

If those criteria are met, then stay the course -- the fund will likely pay off in spades.

Staying the course
There are countless examples of terrific funds that encounter short-term lagging performance, including one that few people could criticize -- Dodge & Cox Stock (DODGX).

This fund has been a favorite of investors for many years, thanks to a 15-year track record that places it ahead of 99% of its large-value peers. In the past two years, however, the fund has lagged the S&P 500 by a cumulative 10.7%, prompting some investors to jump ship.

But nothing fundamental has changed -- it still has the same experienced team at the helm, and it follows the same value-oriented investment approach that has produced a great long-term track record.

In fact, the team at Dodge & Cox sees the current market volatility as a chance to snap up attractive stocks that have fallen on hard times -- setting the fund up to return to outperformance when the market recovers. Recent additions to its holdings include Cadence Design Systems (Nasdaq: CDNS  ) , Credit Suisse (NYSE: CS  ) , Koninklijke Philips Electronics (NYSE: PHG  ) , and Synopsis (Nasdaq: SNPS  ) .

The fund also holds a lot of stocks that the market hasn't liked in recent months, including Sprint Nextel (NYSE: S  ) , General Motors (NYSE: GM  ) , and Ford (NYSE: F  ) . Dodge & Cox's contrarian mindset calls for picking up unloved stocks before the rest of the market rethinks its position.

Investors who've abandoned this fund during this short-term underperformance will likely be kicking themselves in a few years.

The Foolish bottom line
Investing for the long term isn't easy, but it's the single best thing you can do for your portfolio's health -- and that means not getting rattled when your managers have short-term stretches of underperformance. Find the best money managers out there, and stay with them for the long haul.

If you want some help identifying the best fund managers, check out the Fool's Champion Funds investment service. We scour the fund universe and bring the best managers right to your doorstep. You can see all of our picks -- as well as model portfolios and manager interviews -- with a 30-day free trial. Click here to get started -- there's no obligation to subscribe.

Amanda Kish heads up the Fool's Champion Funds investment service. At the time of publication, she did not own any of the companies mentioned herein. Sprint Nextel is an Inside Value recommendation. The Fool's disclosure policy sticks to its guns.


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