In a topsy-turvy world, you have to keep a long-term perspective. But that doesn't mean you should let fading performers take advantage of your patience.
More than anywhere else, investors often get tripped up by references to long-term historical returns from mutual funds. Many funds manage to put up impressive track records over a fairly long period of time. If they suddenly start doing badly, short-term investors start getting concerned right away, but those with longer time horizons tend not to lose faith so quickly. It may take several years of underperformance before long-term investors get the hint that their fund can no longer produce the strong record that it did in the past.
A well-known turnaround
Investors in many famous funds have recently experienced this phenomenon firsthand. After 15 years of outperforming the S&P 500, Bill Miller's Legg Mason Value Trust (LMNVX) finally lost to the markets in 2006, rising only about 7% while the general market increased nearly 16%. Yet many shareholders paid little attention, knowing that such a long streak of outperformance had to end at some point.
Unfortunately, those who stuck around to see how the fund would do were punished severely. By the end of January, the fund had lost over 60% of its value since 2006, making big bets on stocks like Freddie Mac that backfired. Even now, Miller believes the financial industry will recover strongly, putting investors' money into JPMorgan Chase
One down on Wall Street
Perhaps an even sadder story is that of Fidelity's famous Magellan Fund (FMAGX). When Peter Lynch ran the fund in the late 1970s and 1980s, he achieved great success by investing in well-known companies like Philip Morris (now Altria
Yet those who had to fill Lynch's shoes after his departure didn't fare quite as well. Over the past decade, the fund has struggled as its growth-investing focus largely went out of favor. Magellan lost over 49% in 2008, far worse than the average growth fund as well as the S&P 500. And it too has suffered from bad stock picks, with top holdings like Nokia
Obviously, you can't jump ship the first day a fund drops one or two percentage points. But if you've stayed invested with a mutual fund for a long time and enjoyed a good run of success, how can you tell when it's time to move on?
The answer is that there aren't any surefire signs that you need to get out right now. But a few rules of thumb may be helpful:
- If a fund enjoyed great success during the tenure of a particular fund manager and that manager chooses to leave, then you shouldn't take the fund's historical returns into account in evaluating the new manager.
- One trait of great fund managers is their ability to adapt to changing market conditions. If a manager seems resigned to keep doing the same thing even when the market repeatedly knocks the fund down, you're paying for a very expensive lesson on market dynamics for your fund manager.
- If you see a large outflow from a fund, act quickly. You don't want to be the fund's last shareholder.
Lately, of course, the bear market has knocked so many funds for a loop that their past performance doesn't look nearly as good as it did back in 2007. Nevertheless, that won't stop some funds from talking about relative outperformance.
So, if you find a fund that touts its winning record in the new millennium, stop before you buy -- and make sure there's a reason to think that good performance will continue into the future.
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Fool contributor Dan Caplinger stuck it out too long on a former high-flying fund. He owns shares of GE and Altria. JPMorgan Chase is a Motley Fool Income Investor selection. Nokia is a Motley Fool Inside Value pick. Staples is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy keeps the lights on for you.