In this Newsletter, I will discuss some of the most common considerations most people make when selecting a mutual fund, and then subsequently, when adding to their initial investment or selling shares from it. I will then give some reasons why these seemingly sensible actions often lead to a less than satistifactory outcome down the road.
1. "I chose Fund A because it has a great track record." Well, OK, but have you considered how the fund achieved its results? That is, did the fund take what might be considered extreme risks during a period of highly favorable market conditions. If so, the extremely good results previously seen could easily become extremely bad results when market conditions turn negative, much as they have in recent months.
2. "I chose Fund A because someone recommended it to me." Again, maybe OK, but do you know for sure that you have similar goals to that person? Perhaps, for example, the other person likes the fund because it is an extremely aggressive fund, while you, on the other hand, may be more comfortable with a slower, steadier, and more even performer. Or perhaps, if that other person is an advisor, he/she will receive a commission as a result of the fact that he persuaded you to accept his recommendation. Not necessarily very objective sounding, is it?
3. "I chose Fund A because it had a high "star" rating from Morningstar. Unfortunately, the number of stars a fund receives is determined mainly by past performance. Therefore, it is reasonable to assume ONLY that the fund will continue to excel IF past trends hold up. As a useful exercise, you might want to check how many poor performing growth funds over the last year have high star ratings while how many value funds, which in some cases are up in the vicinity of 20% over the same period, have mediocre to low star ratings.
4. "I chose Fund A because it is part of a great fund family." However, even great fund families have their dogs. And, especially if you are attempting to diversify by adding a new fund, you may want to consider a totally different family since funds operated under one family may share similar research teams, approaches, etc. (An example of the latter: many of the Janus growth funds.) Or, perhaps the type of fund that is best suited for your portfolio isn't available within a particular family, in spite of its generally excellent offerings.
5. "I bought more shares of Fund A because the price kept going up." This seems to be the most common reason for buying more shares. If this was your reason, however, did you investigate why this might have occurred, and ask yourself if this condition was likely to persist? For example, if a stock fund's price kept rising and you concluded that the reason was because it was highly weighted toward one or more industries or an overall economy that was currently doing particularly well, did you have a basis for thinking that this economic good fortune would continue to roll on? If you did not ask yourself these questions, then a continuously rising share price may turn out to be more of a warning signal than a harbinger of good tidings ahead.
6. "I bought more shares of Fund A because the price kept dropping and it seemed like a bargain." But once again, did you feel you had an understanding of why the price dropped and a sense as to whether the precipitating conditions were likely to improve any time soon? Unfortunately, it is often only wishful thinking which convinces us that something is so beat up it has to turn around soon. Investing in mutual funds that invest primarily in Japanese stocks has proven to be just such a case - there has still not been a true turnaround in the Japanese economy for roughly an entire decade! Trends once established usually last far longer than anyone expects; see Newsletter 12 which should open your eyes to this phenomena as it has mine.
7. "I bought more shares of Fund A because I had some extra money at the time and I didn't know what else to do with it." But when in doubt, it probably makes more sense to hold such cash in a money market fund until you determine a more specific reason for making an additional investment into an existing fund.
8. "I sold shares of Fund A because the fund was doing poorly." This may be a good reason to sell shares but it may make much more sense to consider selling shares when the fund is doing well, assuming that you have realized a nifty profit. After all, you will definitely not achieve your goal of profiting from an investment if you sell for a loss vs. selling for a substantial gain even when you may not have achieved the highest possible gain, something that is always unknowable in advance. Some of the wisest investment decisions may result from adopting a contrarian attitude because the actions of the majority of investors are often ill-timed and based unduly on past information rather than a consideration of future possibilities.
9. "I sold shares of Fund A because I found that another fund, Fund B, was doing better." True, this may make sense in some cases. Remember, however, that when a decision involves more than one fund, in order to come out ahead, you generally have to be right in both cases, not just one.
For example, in selling A to buy B, you are usually predicting that A won't do very well and B will. But if it turns out you are only partially right, that is, if B does not do very well either, or, if A winds up doing just as well as B, you will not have gained anything AND you may owe additional taxes as a result of the exchange. Put in different terms, if each choice of doing better or worse has a 50/50 chance of being right, your probability of having both outcomes go as you expect is just 1 out of 4! That is, .50 times .50 equals .25.
10. "I sold shares of Fund A to realize a loss for tax purposes." This is most helpful if you were planning to sell the shares anyway or if you are subsequently able to repurchase the shares to make back the loss. But just because you get a tax break does not make up for a loss! For example, if you sell a fund for a loss of $1000 and the loss is a long-term loss, perhaps you will be able to save approximately $200 on your taxes. But you are still in the hole by $800 unless you can use your sold assets to gain $800 elsewhere. So beware of so-called tax loss selling. It may cost you more than you think.
If you have any questions or comments on these 10 all-to-common mistakes, or if you don't think they really are mistakes, please let me know.
Tom Madell, PhD