The question from a California reader is simple enough: How long do you hold on to a stinker of a mutual fund?
Before you can answer the question, however, you have to know one thing: Is it really a stinker in a class by itself? Or did it just stink like everything else?
Q: In my 401(k), a lot of mutual funds have either recovered or are close to recovering from where they were a year ago. However, I still have mutual funds that are down 20 to 30 percent from their highs. My question to you is how long should I hold these mutual funds to allow them to recover, or should I sell them now for a loss and move into something else?
- D.J., Manteca, Calif.
A: D.J., I would agree now is a great time to review the mutual funds in your 401(k) plan. It would have been tough to make a rational decision about whether to switch funds during the market meltdowns late last year and early this year.
But now that we've experienced a bit of recovery and investors are feeling more confident, it's easier to make a sound decision that is not driven by panic.
The first thing I would do in reviewing your mutual fund holdings is to straighten out the time periods you're using for comparison.
In the first part of your question, D.J., you say many of your funds are close to recovering from where they were a year ago. But then in your next statement you say other funds are still down 20 to 30 percent from where they were at their peak.
Do Your Funds Mirror What Happened in the Market?
The problem with those comparisons is you're using two different time periods -- a year ago and two years ago. During that time, the stock market displayed extreme volatility.
If you're using a one-year time frame, then, yes, many of your stock mutual funds are likely back to where they were. In fact, they should actually be higher than a year ago, given that the Standard & Poor's 500 Index -- a broad-based measure of U.S. large cap stocks -- is up about 18 percent over that time.
But the peak value for many of your funds likely occurred about two years ago, sometime in October 2007 when the S&P 500 reached 1,562 before falling to less than 900 earlier this year. Today, it has recovered to about 1,071, up from a year ago, but down 31 percent from two years ago.
So if you own mutual funds that remain down 20 or 30 percent from a peak two years ago, then that is not necessarily a sign that it's time to dump those funds. Performance like that may mirror what's happened in the overall market, and the funds in question may still be worth owning.
A second thing to consider is how much money you've poured into them over the past year. Have your holdings returned to previous levels because of your contributions, because of performance, or some combination of the two?
To answer your question about whether to keep or dump a fund, compare that fund against an appropriate index. Large-cap funds, those that hold shares of the biggest companies, should be compared against a large-cap index like the S&P 500. A small-cap fund should be measured against an index like the Russell 2000.
For international stocks, a popular measure is the MSCI EAFE Index, which measures the performance of stocks in developed nations outside of the United States. That means if an international fund you own inside your 401(k) account substantially lags behind the MSCI EAFE Index over comparable periods, then it might be time to sell that fund and move into a similar international fund.
Just make sure you're using the same time frames for the comparison between fund and index. In fact, I'd look at several different time frames, maybe over one-, three- and five-year periods.
If you do decide a fund should be replaced, check to see if there is a similar type of fund to replace it with. In fact, there may none.
One of the problems with 401(k) investing is that your investment options often are quite limited. You have to work with what you've got because most plans offer a limited range of fund choices.
So, when putting together a 401(k) investment portfolio, first look to see which funds are available among the major asset classes: U.S. large and small cap stocks, international stocks, domestic bonds and cash.
Expensive Funds: Worth It?
If you have more than one fund within each category, then try to find the best choice within each of those categories. Consider the fund's performance compared to a benchmark. But also look at each fund's expense ratio. As a general rule, lower-cost funds outperform more expensive ones.
The lowest-cost funds tend to be index funds designed to track a particular index like the S&P 500 or the Russell 2000. All other things being equal, I favor index funds over an actively managed fund when putting together a 401(k) portfolio.
If your fund choices are limited, you may need to go with a less than stellar investment to be sure you're invested in a given asset class. For instance, a mediocre bond fund is a better option than having no bonds at all in your 401(k).
One thing I would avoid at all costs is simply picking the four or five best- performing mutual funds in your plan over the last year or two. That would likely mean over-concentration in one or two asset classes that have done well recently and underweighting in other areas that are candidates to outperform in the future.
As you can see, D.J., the answer as to whether to keep or dump a particular mutual fund can get quite involved.
But the first thing to do is to make appropriate comparisons, using the right time frames and benchmarks. That will point you in the right direction.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at firstname.lastname@example.org.