It's hard for anyone to bear bad performance from a mutual fund, and it's easy to succumb to the temptation to sell your shares the moment losses rear their ugly heads. On the flip side, it's just as easy to remain stubbornly dedicated to the fund you so carefully researched and chose, even when reality suggests it won't serve you as well as you hoped. When should you hold tight to your mutual funds, and when should you jump ship?
Why we cling to bad funds
There's a big psychological reason for bad fund decisions: Most fundholders hate to sell at a loss. "Sure, my fund is down 20%, but if I can only hold on until I break even, then I'll sell!" People hate to admit they made mistakes, and they tend to hold on in hopes of eventually justifying their purchase. Don't fall into this trap. If your fund no longer meets the initial criteria for which you bought it, cut your losses and move on.
Regular fund monitoring needs to be a part of every Fool's investment strategy. It's not enough to find a handful of good funds, and then sit back and put your portfolio on autopilot. You need to ensure that your fund managers are still delivering all the performance they promised you.
Less is more
Still, that doesn't mean you should head for the exits the first day your fund suffers losses. These kinds of frequent adjustments to your portfolio are a recipe for disaster. If you try to move into the best-performing funds every three months, you're only chasing performance, which is never a good investment strategy. By all means, examine your funds thoroughly each quarter, but don't sell in and out of them frequently -- especially based on just one year's performance.
Even good funds will have a bad year here and there. Get rid of them on a passing impulse, and you may very well miss any recovery the fund experiences. Remember, you want to buy low and sell high. Trade in and out of funds like a maniac, and you're effectively doing the exact opposite -- selling funds that are down, and buying funds that are up.
Unfortunately, it's impossible to pinpoint exactly when you should nix a fund for bad performance. The breaking point will vary from fund to fund, depending on the reasons behind the underperformance (market environment, management decisions). But generally, one year in the dumps isn't reason enough to sell. Consider the performance in the context of the market environment, and use that analysis in your decision.
Now, if a fund underperforms for two straight years? Maybe it's time to think about selling. Three years? Probably. You want to get out of bad funds in a timely manner, but you don't want to get rid of good funds that just have a stretch of bad performance.
It's a fine line, and you'll only be able to walk it by paying close attention to what your funds are doing, and how the market's faring in comparison. Doing so will put you ahead of the majority of fund investors right out of the gate, leaving you in a much better position for investment success.
Other reasons to sell
Bad performance isn't the only thing to watch out for in a fund you own. Other factors, such as manager departures or a drift away from fund objectives, also are warning signs.
Once its manager leaves, a fund's past performance, whether good or bad, likely matters very little in predicting how the fund will perform in the future. Even when new managers have a vast amount of experience, they likely don't have an established history of managing that particular fund, which means that you can pretty much kiss its prior track records goodbye. Some new managers can certainly do as well or better as the people they replace. We're simply saying that when a new manager takes the helm, past performance no longer becomes a valid factor in judging whether a fund's worth keeping.
In addition, a fund should keep investing consistently with its stated objectives. For instance, if a small-cap fund moves heavily into mid-caps because it has too much money to invest, or if a value-oriented fund suddenly starts chasing pricey growth stocks because they're currently in Wall Street's favor, your original thesis for owning the fund may have changed. That might also be a reason to sell.
We hope you've enjoyed these articles. But really, this is just the tip of the iceberg for mutual fund know-how. At our Motley Fool Rule Your Retirement newsletter service, we go into great detail on how to put together a portfolio of mutual funds and other investments that are suitable to help you reach your long-term financial goals. Try it out, and we'll make sure you keep learning what you need to know. Happy investing!