So you’ve just reviewed your mutual funds in your 401k or your private account and discovered that one of your funds only returned 5% last year while other funds returned 10% or 20%. What are you going to do?
Many people would sell the fund that performed poorly and buy the one that returned 20%. After all, that manager might have some secrets that allow him to generate those 20% returns. Why would someone want to settle for a paltry 5% return when one could get 20%?
One must be careful to read that little disclaimer that is at the bottom of all mutual fund advertisements: “Past performance may not be indicative of future results.” No one is able to accurately predict how a certain stock will do over one year. There are just too many things that can happen int he mean time. Even if the company does well, public opinion may sour on the company and the share price decline anyway. Or maybe they’ll double earnings, but people will expect them to triple earnings, so they’ll drop off in price when earnings are announced.
Just because a stock fund does poorly in any given year does not mean that it will do poorly the next year. Buying that stock fund that shot up 20% may also mean that you are buying a group of stocks that are now overpriced and ready to fall or just sit there for the next four years. It is the result of this chasing performance that most people buy stocks right before they are ready to fall off and sell them just before they are ready to shoot up.
If a mutual fund is performing poorly relative to other funds, one should see if it is that the sector of the market that the fund is in just performed poorly or there is something wrong with the fund itself. Because funds own so many different stocks, it is unlikely that they can actually lag their overall market over a long period of time unless their fees are relatively high. If the sector just performed badly, perhaps large caps only went up 5% while small caps shot up 20%, it may well be that large caps are due for a rally the next year. If one sells the fund now, he would miss a large gain.
So if a fund performs badly, do the following:
1) Check the fees compared to other similar funds. If fees are high (greater than 1%), it would be wise to change to a less expensive fund in the same sector. index funds tend to have very low fees.
2) Evaluate the segment of the market and decide if you are in the right sector. If you are in an emerging markets fund the performance will likely be all over the board with some spectacular years and some dismal years. If you buy a bond fund it will not perform as well as a stock fund over a long period of time, but int he bad years it will probably hold up better. For example, in 2008 stocks fell more than 20% while bond funds generally had a positive return. It is therefore a good idea to own funds in different segments of the market with the balance depending on how long you have to invest the money.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.