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When to dump an underperforming fund

If you've been watching your mutual funds go down, down, down lately, your initial reaction may be to sell.

Cutting your losses may be the right answer in some situations, but financial advisers caution consumers that impulsively dumping an underperforming fund may be a costly mistake in the long run.

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"Investors must do their homework in order to make informed decisions regarding the liquidation of an investment fund," says Joan Moffitt, CPA, senior tax manager at Weiser LLP in Edison, N.J. "Only then can they leave their emotions out of the decision-making process."

While it can be discouraging to watch an investment drop, many experts agree that taking a step back and rationally evaluating the holding is likely to yield better results than a hurried sale.

"There are a lot of subjective variables to consider in addition to all the quantitative data," says Gordon Peterson, chief executive officer of International Research and Asset Management in Dallas. So before you sell, research all the data.

Before you sell, consider these points

Is it the fund, or is it the market?
"Even stellar managers go through periods of underperformance," says Mark Brown, a Certified Financial Planner and managing partner of Brown Tedstrom, an investment advisory firm in Denver. "If they're down, it may be that everyone in that asset class is down as well."

Pete Martinez, president of Insight Financial Services in Overland Park, Kan., warns investors not to sell a solid fund just because it has declined in a down market. "We don't believe that mutual funds are timing instruments," he says.

Bonnie Hughes, a Certified Financial Planner with A&H Financial Planning and Education in Kennesaw, Ga., counsels individuals not to sell during market volatility or in periods where the fund is at the bottom of a natural market cycle.

"Unless you have a crystal ball, who knows what will be in favor next year?"

Hughes steers clients to a popular chart produced by Callan Associates. The Callan Periodic Table of Returns tracks performance of different asset classes over time, illustrating that no one asset class consistently remains a top performer.

How does the fund fit into your overall portfolio?
Because different asset classes perform differently from year to year, combining them in a meaningful asset allocation is critical.

"One of the key determinants of good investment performance is proper asset allocation," says Moffitt, referring to the process of diversifying a portfolio among different types of investments, such as stocks, bonds, and cash in order to maximize return while minimizing risk. Before selling an underperforming fund, she advises investors to review the role of the fund in the portfolio.

"If your fund is not performing well as part of the overall allocation, you might consider replacing it," she says.

How long has the fund been underperforming?
"If you've picked what you thought was a good manager for the right reasons, then give him some time," says Brown.

Peterson waits for an extended period before making a decision to sell based solely on returns. "Many studies show that a manager can underperform for seven or eight quarters and still outperform the market over the long term," he says. "I want a manager to be in the top third of his peer group. If the fund drops below 50 percent on a three- or five-year basis, then I would terminate."

Martinez agrees, saying that if a fund's three-year annualized performance dips below the corresponding index, they officially put the fund on "watch" and after five years, they put the fund on "warning," which ultimately culminates in a decision to sell or continue holding.

 
 
Next: "You might have to say, 'Oops, I made a mistake.'"
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