Mutual Funds: Knowing When to Fold 'Em

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?

Looking for financial advice? Click here to send David your questions and they might end up as a topic for his next column.

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.

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