Many financial advisors and academics do not recommend selling stocks and mutual funds when prices are tumbling, during bear markets. If you can just hold on through thick and thin, they argue, you are likely to enjoy returns better than any other asset class, over the long run; an average annual yield of 6.5 to 7% after inflation, according to Professor Jeremy Siegel's, "Stocks for the Long Run." However, there are occasions when selling a mutual fund might be warranted; buy and hold is not forever. Here we look at the top eight reasons for selling a mutual fund.
Tutorial: Mutual Fund Basics
Over time, trends in financial markets might cause asset allocations to diverge from desired settings. In other words, some mutual funds can grow to a large proportion of the portfolio, while others shrink to a smaller proportion, exposing you to a different level of risk.
To avoid this outcome, the portfolio can be rebalanced, periodically, by selling units in funds that have relatively large weights, and transferring the proceeds to funds that have relatively small weights. Under this rule, the time to sell equity mutual funds is when they have enjoyed good gains over an extended bull market and the percentage allocated to them has drifted up too high. (To learn more, read Rebalance Your Portfolio To Stay On Track.)
Mutual Fund Changes or Mismanagement
Mutual funds might change in a number of ways that can be at odds with your original reasons for buying. For example, a star portfolio manager could jump ship and be replaced by someone lacking the same capabilities. Or there may be style drift, which arises when a manager gradually alters his or her investing approach over time. (For more insight, check out Style Drift Can Hurt Mutual Fund Returns and Should You Follow Your Fund Manager?)
Other signals to move on include an upward trend in annual management expense ratios (MERs) or a fund that has grown large, relative to the market. If the fund has grown large compared to the market, managers could have difficulty differentiating their portfolios from the market, in order to earn above-market returns.
As you gain experience and acquire more wealth, you may outgrow mutual funds. With greater wealth comes the ability to buy enough individual stocks, to achieve adequate diversification and avoid MERs. With greater knowledge comes the confidence to do it yourself, whether it is actively picking stocks or buying and holding market indexes, through exchange-traded funds (ETFs).
Life Cycle Changes
Although stocks historically have been the best investments to own over the long run, their volatility makes them unreliable vehicles in the short term. When retirement, children's post-secondary educations, or some other funding requirements approach, a good idea is to shift out of stock-market funds into assets that have more certain returns, such as bonds or term deposits, whose maturities coincide with the time that the funds will be needed. (To learn more, read The Seasons Of An Investor's Life.)
Sometimes, investors' due diligence is incomplete and they end up owning funds they otherwise would have not purchased. For example, the investor might discover that the fund is too volatile for their tastes, a closet-index fund with a high MER, or invested in undesirable securities.
Portfolio errors might also have been committed by the investor. A common mistake is over-diversifying with too many funds, which can be difficult to keep tabs on and can tend to average out to market performance (less fund fees).
Another common misstep, is to confuse owning a large number of funds with diversification. A large number of funds will not smooth out fluctuations, if they tend to move in the same direction. What's needed is a collection of funds, of which some can be expected to be up, when others are down.
Shift out of mutual funds to rebalance your fixed portfolio allocations, by using a flexible or opportunistic approach. A common valuation yardstick is the price-earnings ratio (P/E ratio); for U.S. stocks, it has averaged 14 to 15 over time, so if it rises to 24 to 26, valuations are overextended and the risk of a downturn is elevated. (See P/E Ratio: Introduction, for more.)
Something Better Comes Along
Investing legend Sir John Templeton, advised selling whenever something better came along. In the mutual fund realm, some funds can come onto the market with innovations that are better at doing what your fund is doing. Or, over time, it may become apparent other portfolio managers are performing better, against the same benchmarks.
Mutual funds held in taxable accounts, might be down substantially from their purchase price. They can be sold to realize capital losses that are used to offset taxable capital gains and thus lower taxes.
If the sale was solely to realize a capital loss for taxation purposes, the investor will want to re-establish the position after the 30-day period required to avoid the superficial-loss rule. The investor might take a chance that the price will be the same, lower or might choose to hold a proxy for the fund's price movement.
Tax-loss selling tends to occur during August to late December. That's also the period when many funds have estimated the capital gains and income they will be distributing to investors, at year end. These amounts are taxable in the hands of the investor, so an additional reason to sell a losing fund from, the tax point of view, may be to avoid a large year-end distribution that would require paying additional taxes. (Read Capital Gains Tax 101 , for more insight.)
The Bottom Line
Although these eight reasons should compel you to consider getting rid of your fund, remember to keep the impact of deferred sales charges, short-term trading fees and taxes in mind whenever you sell. If these other factors don't fall in your favor, it may not be the best time to get out.