When Should You Sell A Losing Mutual Fund?

Predictably, investors have been selling equity mutual funds in droves, opting for the safety of cash and bonds.  While moving to cash isn’t something I recommend, it’s an understandable reaction to the current economic situation.  It’s not a rational move, however, and here’s why:

1. You can’t go back in time – Selling out now won’t change the fact that you’ve already lost a lot of money.  What matters is what’s most likely to happen in the future, not what happened in the recent past.
2. Buy low, sell high – Selling out at the bottom is buying high and selling low, which is the exact opposite of what you should to do.  As it turns out, doing the right thing in investing requires you to ignore gut-wrenching volatility.  If anything, now is the time to buy.

That said, there are certain situations where it makes sense to sell a mutual fund.  Maybe your goals have changed or a former star manager has lost his touch.

When To Sell An Index Fund

There are really only a few reasons to sell an index fund, and they are relatively rare.

1. A cheaper fund exists – Since a lower-cost index fund will always out-perform a higher-cost index fund tracking the same index, it makes sense to trade up to the less-expensive fund if the difference is significant.  NOTE: This only applies when you’re trading within a tax-advantaged account such as an IRA or 401k, since any cost savings would be eaten up by the tax bill in a regular taxable account.
2. It’s a non-core fund you don’t really need – These days, there are index funds tracking practically any market you could think of.  While some sector indexes most definitely have a place in your retirement portfolio (like REITs, which count as a separate asset class), most don’t.  If you find yourself holding a lot of non-core sector index funds (such as energy, mining, technology, etc) it may make sense to sell them off and get back to the basics.
3. You have over-lapping funds – Owning over-lapping funds makes no sense.  Just go with the less expensive of the two.  To find out if you have any over-lap, I recommend using the Morningstar Portfolio X-Ray tool (free registration required).

That’s all I can think of for index funds.  Let me know if I’ve missed something!

When To Sell An Actively-Managed Mutual Fund

Hopefully you’ve done your homework and picked a great mutual fund to begin with and can leave it at that, but even the best mutual funds go through rough spells.  As an example, the Dodge and Cox Stock fund (DODGX) has one of the best 10-year track records around, returning an annualized 3.12% per year over that time period and beating its index by a wide margin.  Its 3-year record, however, puts it near the bottom of the barrel, having lost over 17% per year over the last 3 years.  Is Dodge and Cox Stock a bad fund?  Of course not, it’s simply hit a rough patch and yes, has made a few mistakes.  The trick is to separate the good funds that have hit a rough spot from the bad funds unlikely to ever beat their benchmark in the future.  Here’s what to check before you decide to sell (or buy) an actively-managed mutual fund.

1. Do its long-term performance numbers stand up? Past results are no guarantee of future success,  but why waste your hard-earned cash on a mutual fund with a poor long-term performance record?  It makes sense to buy the best and if what you own doesn’t fit the bill, it makes sense to make a switch (taking taxes into consideration, of course).  If, on the other hand, your fund’s long-term numbers are still near the top of its category even taking recent losses into consideration, it probably makes sense to stay put.  Just be sure to compare apples to apples when evaluating mutual fund performance.
2. Has the fund’s strategy changed? A strong long-term record doesn’t mean anything if the strategy used to generate those returns is no longer being used.  Dodge and Cox still employs the same strategy it’s used successfully for decades, which lends credence to the idea it’s just hit a temporary rough patch.  More likely than not, the fund will return to its former brilliance when its investment style comes back into favor.
3. Has the fund’s manager changed? Just as above, a strong long-term record means nothing if the manager responsible for it is no longer around.  Peter Lynch is the most obvious example of this.  Lynch steered Fidelity’s Magellan fund (FMAGX) to stellar returns and made many of his original shareholders very, very wealthy.  After Lynch’s retirement, the fund almost immediately began to lag not only the market but its actively-managed competition.  Who knows of Magellan will ever regain its former glory?
4. You want to buy an index fund! I’m a big proponent of index investing and would strongly urge you to consider an all-indexed portfolio.  If you happen to own one of those rare gems that beats the market year in and year out (let me know if you’ve found one, by the way), then by all means stick to what works.  For the rest of us, indexing represents the best chance we have of growing our nest egg.

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