Emotions play a big role in your life, but they can be downright dangerous to your finances. When emotions drive your investment decisions, you might let fear of missing out drive you to buy at the top of the market. Or you might sell at the bottom, in a panicked attempt to limit losses. Either strategy ensures that your returns will be well below market averages.
That's easy to understand, but much harder to avoid in practice. Market volatility can lure the most seasoned investor into making rash decisions: It's human nature. Combat the panic in these turbulent times by getting back to basics. Assuming you are a long-term investor, there are only five main reasons you should be selling your mutual funds.
1. The fund is underperforming relative to its peers.
Some funds are duds. Usually, high fees or a fund manager's poor investment choices are the culprits. The thing is, you can't immediately assess a fund's performance by looking at its returns. You have to consider how the fund is performing relative to its peers.
There are two reasons peer comparisons are important. First, you don't want to attribute poor performance to the fund manager when it's really a function of market trends. And second, assuming you have a strategic reason for investing in that category, you should only sell when there's a better option available.
Start by checking the fund's Morningstar rating, which you can do for free at Morningstar.com. If the fund has less than a five-star rating, there are better options in that same category. You can also search the fund on Yahoo! Finance, click "Performance," and view its category rank in different time periods. Or use a mutual fund screener of your choice to browse the highest-performing funds by category.
If you find better fund options to fill the same role in your portfolio, go ahead and dump the dud and replace it with a high performer.
2. You need cash and your portfolio is your only source.
Life throws curveballs. You might face a surprise expense that can't be covered by your emergency fund. In a pinch, you could borrow from your 401(k) or liquidate investments within your brokerage account to raise the cash you need.
Before you take that step, though, make sure it's really your best option. The financial impact of lost earnings can be substantial over time. Say you pull $10,000 out of your retirement account. Assuming you're earning 7% annually, you'll miss out on $30,000 of earnings over the next 20 years.
It might make more financial sense to tap a home equity line of credit or sell some of your belongings to free up the money you need.
3. You reached a financial goal.
There's always an underlying purpose to saving. Most of us save for retirement, but you might also save to buy a home, to start your own business, or to fund your kid's graduate-school education. At some point in time, you reach the target savings goal and liquidate to cover the expense. That's a sensible reason to sell off mutual funds; retirees do it every day.
4. You need to manage your tax bill.
If you are investing in a taxable account, tax implications will drive some of your decision-making. This often comes in the form of tax-loss harvesting, which is the practice of using investment losses to lower your tax bill.
From a tax perspective, capital losses offset your capital gains. But you can also use up to $3,000 in capital losses to offset other types of income, like dividends. If you have dividend or interest income, you may choose to sell off underperforming mutual fund shares to create an offsetting loss.
5. You're rebalancing your portfolio.
Rebalancing is the process of selling some investments and buying others to achieve a specific asset allocation. In normal market conditions, equities and equity funds grow faster than bonds and bond funds. Over time, that can leave you with too much equity exposure and not enough debt in your portfolio.
To fix that, you'd sell off equities -- say, your mutual funds -- and buy more debt. You might choose to sell your lowest performers or a strategic mix of gainers and losers to minimize the tax implications.
Say no to emotional selling
If you're investing for the long haul, don't let short-term market trends lure you into selling. Instead, lean on relative performance, your financial situation and goals, tax needs, and the overall health of your portfolio to drive your investment decisions.