So When Do You Sell, Anyway?

Ann C. Logue | May 05, 2008 12:00am EDT | Comment

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Although the game is to buy low and sell high, it's really hard to know what's low and what's high because those numbers are relative. We're going through a rough market right now, and some people are selling out of panic. That's the wrong thing to do. But it may be a good idea to get out of mutual funds that are underperforming by a big margin in a bad market. How do you tell which is which?

Doug Fabian, a financial planner and president of Fabian Wealth Strategies in Costa Mesa, Calif., wonders why so many bad mutual fund managers are allowed to stick around. Each quarter, he publishes his Lemon List (www.mutualfundlemonlist.com), which is a list of mutual funds that have underperformed their peer groups for the last 12, 36, and 60 months. The goal is to separate out funds that are going through a temporary rough patch from those that are posting bad numbers year after year. "If you turned up on the Lemon List, then you didn't have a bad quarter," he says.

The 10 largest funds on his most recent list are Fidelity Equity-Income (FEQIX), Templeton Growth A (TEPLX), Fidelity Growth & Income (FGRIX), Fidelity Dividend Growth (FDGFX), Vanguard Windsor Fund (VWNDX), Van Kampen Comstock A (ACSTX), Vanguard Asset Allocation (VAAPX), Longleaf Partners (LLPFX), Fidelity Investment Grade Bond (FBNDX), and Vanguard Pacific Stock Index (VPACX). Fabian notes that these funds tend to have high fees that can be tough for even the best fund managers to beat.

Besides fees, he thinks investors should look at two other factors when deciding whether to sell a fund. The first is whether the fund manager is close to retirement. An underperforming manager might be allowed to coast if he is almost 65, and a star manager might be replaced with someone who can't match the performance record. The second is how the fund does in a down market. He recommends that investors go to Yahoo! Finance (finance.yahoo.com) and pull up a chart comparing their fund to the S&P 500 over 10 years to see how the two match. "It makes no sense to hold on to something that isn't working," he says.

The analysis can also show if a fund's recent lows present a buying opportunity. If the fund has low fees, a good manager who is not 64 ½ years old, and has an historical tendency to track the market when it's down and beat it when it's up, then it may be time to add to the position.

No matter how the fund and the market are doing, investors need to assess whether their investments fit their needs. It should be a regular process. Did you get a big raise so that you can afford to take more risk? Are you in the tenth year of retirement and ready to cut back on risk a bit? Do you have a child heading to college next year, so you need to raise cash? Those factors can be more important than market performance.

But the hardest part is overcoming mental blocks. Modern finance has been based on the assumption that investors are rational and markets are efficient, even though it's clear to anyone who has spent any time investing that neither assumption holds. The newest branch of finance, behavioral finance, looks at how investors really behave. So far, the findings indicate that people fear loss more than they value gain, that they prefer to do what everyone else is doing, and that they overreact to short-term information.

Portfolio managers are human beings, and they fall prey to the same emotional pitfalls about stocks that regular investors do (maybe not as often or to the same extreme). They fall in love with companies and just know that next quarter, their patience and loyalty will be rewarded. They are afraid to sell underperforming holdings because that would mean recognizing the loss. They worry about what stocks are in their portfolios, because they'll be more harshly penalized for picking a losing stock that is not in the benchmark index than for picking an even bigger loser that everyone else owns. If they do start outperforming their group, they'll often cut back in order to lock in their bonus rather than keep stretching.

However, the professional's worst impulses are held in check by the threat of firing. Underperform too long, and they are shown the door. If the fund company won't do it, maybe you have to.