In the rollercoaster markets of recent years, many fund investors engaged in self-destructive trading. As markets approached their trough in March 2009, shareholders panicked and began dumping their stock mutual funds.
Then, after markets rallied for several months, the investors became enthusiastic about stocks and began buying funds again. That pattern of trading is hardly unusual. All too often investors sell shares at low prices and buy near market tops.
To appreciate how costly ill-timed trades can be, consider Quaker Strategic Growth, a fund that holds large stocks with growing earnings. If you bought the fund and held it for the 10 years ending in March 2010, your average annual return would be 1.8%, according to fund tracker Morningstar.
But many investors did not hold for the entire period. Instead, they bought near peaks and sold at valleys. As a result, the average dollar invested in the fund actually lost 3.9% annually.
Assessing a fund
How can you avoid making poorly timed trades? For starters, you should have a clear idea of your fund’s track record. If the fund has dropped sharply in the past, then you must be prepared for more trouble in the future. By understanding the history, you are less likely to panic when stocks fall.
For a quick guide to how volatile a fund might be, consider its performance in the decline of 2008. During that year, Quaker Strategic lost 46%, trailing the S&P 500 by nine percentage points. For a smoother choice, consider Vanguard Wellesley, a conservative fund that holds a mix of stocks and bonds. Vanguard lost only 9.8% in 2008.
Another relatively solid choice is Vanguard Dividend Growth, which lost 25% in 2008. The fund buys blue chips with histories of increasing dividends. Such stocks tend to hold their value, even when the markets sink.
Should you stay away from volatile funds altogether? Not necessarily. Aggressive funds like Quaker Strategic can deliver strong long-term returns. But investors who buy Quaker should understand that the fund soars during bull markets and sinks hard when markets decline. That can cause investors to panic and sell at the wrong time. To get the full benefits from the fund, you must be prepared to buy and hold during the hard times.
When should you sell?
Keep in mind that there are two kinds of funds: index funds, which mimic benchmarks, such as the S&P 500, and actively managed funds that try to outdo the benchmarks. Most assets are in active funds that buy and sell stocks in an effort to boost returns.
To decide whether to sell an active fund, compare its performance to a suitable benchmark. For funds that hold large U.S. stocks, you may want to compare results to the S&P 500. Small-cap funds may be measured against the Russell 2000 index of small stocks.
Suppose that a large-cap fund returned 43% during the 12 months ending in March 2010. That looks like a fine performance. In fact, the fund lagged the S&P 500, which returned 49.8%.
Seeing the subpar results, you may be tempted to dump the fund and switch to an alternative that did better in the past year. But experts suggest that you hold a fund for at least three years before throwing in the towel. To appreciate why, consider a study by Matthew Rice and Geoffrey Strotman of DiMeo Schneider, an investment advisor in Chicago.
For the study, the researchers looked at the performance of mutual funds that had finished in the top quarter of their categories for the 10 years ending in 2009. Most of the funds outdid their benchmarks by wide margins, and shareholders should have been pleased with the results.
But even those winners faced significant periods of underperformance. Altogether, 85% of the winning funds had at least one three-year stretch when they ranked in the bottom half of their categories. In other words, even the best managers have long spells of poor performance. So when you buy a fund, you must be prepared to sit tight for years when the manager looks inept. Those shareholders who sold the top funds after one poor year missed the later periods when the funds rebounded and outpaced competitors.
For a reliable active fund, consider Eaton Vance Large-Cap Value, which holds such steady companies as hamburger giant McDonald’s and computer maker Hewlett-Packard. During the past 10 years, the fund returned 5.5% annually, outdoing 86% of its large value competitors. Eaton Vance finished in the top half of its category during eight of the past 10 years.
For a fund that buys large growth stocks, consider American Funds AMCAP, which owns such profitable companies as software producer Oracle and medical device maker Medtronic. During the past decade, the fund returned 2.4% annually, outdoing 94% of competitors. The fund finished in the top half of its category in nine of the past 10 years.
If you don’t like the idea of underperforming the benchmarks periodically, then consider index funds. A top choice is Vanguard 500 Index. Because the fund always mimics the S&P 500, you need never worry about lagging the benchmark.
Buy and hold
Although index funds can be sound choices, they also come with limitations. Index funds tend to excel in bull markets, but they lag many active managers during downturns. This occurs partly because active managers often hold some cash along with stocks. The cash acts a cushion in down markets—and a drag in good times. In contrast, the index funds do not hold any cash. For example, Vanguard 500 Index holds the 500 stocks of the benchmark and no cash.
Whether you choose an index fund or an active fund, the best strategy is to buy and hold for years. By sticking with the markets for the long term, you increase the odds of getting decent returns and meeting your financial goals.