When it comes to investing, everyone wants the inside scoop on the next big thing. Investors practically drool over the chance to nab the next 10-bagger before it takes off and makes its shareholders some serious money. And while buying good investments is one of the primary drivers of success, investors often forget that there is another equally important aspect of the investing game: knowing when to sell.
Patience is the name of the game
Millions of Americans own mutual funds in their retirement or other brokerage accounts, making them one of the most widely utilized investment vehicles around. Unfortunately, far too many investors encounter a mild form of attention deficit disorder when it comes to investing in funds for the long run. If a fund has a particularly bad year or two, odds are good that folks will start yanking money from the fund and looking for greener pastures. Unfortunately, investors with an itchy trigger finger are likely to end up hurting themselves.
A recent study from Chicago-based investment advisor DiMeo Schneider suggests that investors should hold their weakest-performing funds for at least three years. Looking at Morningstar data, the study found that of the funds that landed in the top quarter of their fund categories over the past 10 years, 85% had at least one three-year stretch of time when they landed in the bottom half of their peer group.
I've always tried to hammer home the idea that even the best and brightest names in the business will have periods of underperformance. But few investors have the patience to sit through three years of sub-par returns while keeping their eyes on the larger picture.
Jumping ship too soon
One real-world example of how investors employ this short-sightedness can be observed with the Muhlenkamp Fund (MUHLX). Skippered by guru Ron Muhlenkamp, the fund racked up a first-rate track record in the first half of the decade. From 2000 to 2005, Muhlenkamp posted an annualized 13.9% return, compared to a 1.1% loss for the S&P 500. Assets poured in, and by the end of 2005, the fund boasted just over $3 billion in assets. However, some bad timing on certain market sectors got the fund into trouble in the ensuing years, and the fund lost an annualized 17.6% from 2006 through 2008, 9 percentage points behind the S&P 500. Investors punished the fund, yanking out hundreds of millions of dollars. By the end of 2008, the fund had just more than $600 million in assets.
But folks who fled from Muhlenkamp during its lean years missed out when the fund finally turned the corner. From January 2009 through the end of March 2010, the fund was back on top, outpacing the S&P 500 by nearly 4.5 percentage points a year. Furthermore, investors who fled are likely to miss out on any further gains the fund is likely to see.
Muhlenkamp expects neither a return to robust growth nor a double-dip recession -- just a slow, steady ride ahead. That's smart thinking in this environment, and I think the fund is well-positioned for what lies ahead for our economy. For example, the fund is heavy into health care, one sector I think should outperform in the future. Top holdings Pfizer (NYSE: PFE) and Abbott Laboratories (NYSE: ABT) will likely be two winners from health-care reform, given the expected increase in Americans' consumption of prescription drugs. Both Pfizer and Abbott Labs have meaningful market share in this corner of the market, and both stocks trade at P/Es far below that of the broader market.
Likewise, Muhlenkamp has a decent tech allocation, including top 10 holdings Oracle (Nasdaq: ORCL) and Cisco (Nasdaq: CSCO). I'm predicting that tech spending will rebound significantly as the economy firms up, and firms that dominate the enterprise technology arena, as both Oracle and Cisco do, should see some hefty profits.
I'm not quite as excited about Muhlenkamp's financial allocation to State Street (NYSE: STT) and Bank of America (NYSE: BAC), seeing as the financial sector is likely to remain under pressure for some time. But Ron Muhlenkamp has an excellent long-term track record, and I don't doubt that investors who stick by him will do quite well. Unfortunately, those who didn't have the discipline to hang tough during stretches of underperformance will miss out completely.
In it to win it
If you're a fund investor, you're likely sitting on top of a few funds that haven't measured up to expectations in recent quarters. And while you're almost certainly tempted to ditch those funds and find alternatives with better near-term track records, don't be so hasty. If your funds are still good long-term options, you should probably stick with them. In other words, if they are funds with long-tenured managers or management teams, a consistent investment process, low expenses, and a top-notch performance track record over the long-run, you would probably be better off sticking to your guns and not selling.
Of course, there are times when selling is the right thing to do. If your fund has fundamentally changed its investment process or approach, or especially if a new manager has come on board, then its prior track record doesn't really mean much. Likewise, you shouldn't hold on to losers forever. If your fund still hasn't rebounded after three years and the fund has lagged in a market environment in which it should be expected to excel, you shouldn't feel bad about saying goodbye.
Knowing when to sell is a tricky proposition, but when it comes to mutual fund investing, make sure you're not throwing in the towel too quickly. Good managers deserve some leeway every now and then. If you grant them breathing room, your portfolio will reap the rewards when the tide turns back in their favor.
