Check That Bad Instinct

Studies have revealed that money flows in and out of mutual funds in a poetic, almost natural way -- not unlike the workings of the human heart.

We want to put our money in the best funds we can find. If our funds perform poorly, we take out our money and move it into funds with better records. But  size can harm a fund's performance, and as they get bigger, many funds will see their performance falter. When that happens, shareholders sell, and seek out better-performing funds. On the surface, that makes sense.

But according to a study by Jonathan B. Berk and Ian Tonks, investors will pull money out of poor funds for a while -- but if those funds become truly terrible, investors appear to leave their money in them. What's going on here?

As it turns out, a fund doesn't become a true stinker overnight. First, it has a bad year or two, after which its most sensitive shareholders depart. Then it has another bad year or two -- but its most sensitive shareholders have already departed, leaving less sensitive ones behind. These people are already less likely to sell out. Over time, the fund keeps doing badly, but the shareholders it has left are either not paying attention, or they just don't care.

Don't let yourself become one of those shareholders. Keep an eye on your funds. Here are two stinkers, as examples, and their returns over several years:

Source: Morningstar.

The Frontier fund has averaged an annual loss of around 32% over the past five years, while the Van Wagoner fund has averaged a 24% loss. These are train wrecks you probably could have seen coming.

I suspect this phenomenon happens with stocks, too. The following companies, for example, have posted losses in at least three of the past five years.

Source: Morningstar.

That should have been enough for shareholders to question what was going on, and whether they should stick around. Fools, spare yourself a broken heart and a busted portfolio -- don't put up with long-term bad performance.