Like a lot of investors who have been using mutual funds, Bill W. of Weymouth, Mass., has seen one big change over the years.
Today, he is less interested in knowing what fund to buy than he is in which ones to get rid of.
So when he saw my updated methodology for picking a mutual fund – Bill dropped me a note.
“The story you wrote 20 years ago was one I clipped and used,” he said, “and I built up what I think is a good portfolio over time, and at my age I don’t really want to add funds now so much as just manage my money better. … I don’t need you to tell me how to buy a fund at this point, I need you to help me decide which funds I own that I should get rid of.”
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As with most things when it comes to investing, deciding what to sell is best done with a process that examines the factors while minimizing emotion. Here’s the process I follow:
Step 1: What’s my reason for even thinking of a sale? Is it specific to the fund, my portfolio, or my personal needs?
If you need cash to pay for college tuition or to buy a car, that’s different from wanting to change your asset allocation, or holding a fund that’s underperforming the market or where there has been a change in management.
If your decision is mostly about paying bills and not about owning funds that are laggards, your decision may come down to which fund has grown so big that a sale will trim it back to your preferred asset allocation. That may mean selling a fund that has done well of late.
If you are like Bill W. – looking to consolidate holdings to make his life easier – the decision may come down to eliminating smaller accounts or dropping the lesser of two funds that have significant portfolio overlap. That’s a “this fund or that one” decision, rather than a case of wanting to dump a fund because it can’t keep up with the category averages.
Step 2 : “Would I buy this fund again today?”
Most investors make a fund get over a high hurdle before they’ll buy, but then lower the bar and wind up tolerating performance that never would have passed muster.
In buying a fund, investors should make a list of the reasons that went into their thinking, so that they can use that tally when they review a fund in the future.
If you were attracted by a star manager, by superior performance, by a great rating from an analytical firm – or if you bought the fund because it was the best choice in a former employer’s mediocre retirement plan – and those touch points are no longer a factor, it may be time for a change.
If you wouldn’t buy the fund today, there’s not much reason to keep holding it.
Step 3: If not this fund, which?
If you would not buy the fund again today, what would you own instead? Put yourself through the entire selection process before jettisoning your current holding, because it forces you to look at comparative performance, to reconsider asset allocation and more, leaving you excited that the change will be an upgrade.
Without that excitement for what’s next, you might be dumping a fund for the sake of feeling like you are doing something. That doesn’t improve your portfolio.
Step 4: Examine tax implications, sales charges and more.
In taxable accounts, selling a loser creates a benefit, while dropping a gainer generates a tax bill. Facing a big capital gains bill may be the one thing where you find it worthwhile to stay in a fund you would not buy again today.
You don’t want the tax tail to wag the dog – letting taxes rather than investment strategy dictate your thinking – but don’t put yourself in line to give Uncle Sam a wad of cash without being fully aware of it.
Likewise, if you are paying sales charges to get out the door, consider whether your freedom is really worth it.
Step 5: Have a plan for the proceeds.
If you’re not removing the money to use it, make sure that the sale improves your portfolio by putting the money into something better, and/or by improving or updating your asset allocation.
You set your goals in Step 1; make sure any change accomplishes as many of them as possible.
Step 6: Pull the trigger.
Too many investors stick with bad funds for way too long. Once you have convinced yourself that you are better off making the change and you’re excited for what comes next and willing to take any tax hit that comes with it, make your move and don’t look back.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or at Box 70, Cohasset, MA 02025-0070.