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Should I Sell My Underperforming Funds? ... The Dogs?

“In light of recent market conditions, is it a good time to cut my losses and sell the dogs of my portfolios?” This is a question that many investors are probably asking themselves today, and I would like to share our advice on selling underperforming funds.

First, I want to share our no-load fund “buy-and-hold” investment strategy with you. We believe a well diversified portfolio should be spread across several different asset classes. These asset classes should be non-correlated, tax efficient, and fundamentally sound. Specifically, we feel you should be invested in the following: large US growth stocks, large US value stocks, small US growth stocks, small US value stocks, large international growth stocks, large international value stocks, small international growth stocks, small international value stocks, emerging markets, and short term bonds. Since history, as well as study after study, has shown, you cannot accurately and reliably time the market. So we recommend you invest in every asset class simultaneously. Not only does this reduce your overall risk, but over many years your return will likely be higher.

Let’s take a look at what would happen if we tried to time the emerging markets asset class over the last decade. Below are the returns of the Vanguard emerging markets fund since 1997.

Year Return%
1997 -16.7
1998 -18.1
1999 61.6
2000 -27.6
2001 -2.9
2002 -7.4
2003 57.7
2004 26.1
2005 32.0
2006 29.4
2007 38.9
YTD 9/2008 -34.0

An investor who purchased the funds in 1997 would have been very disappointed because they would have experienced a -16.77% and a -18.1% return the first two years they were in the fund. At that point, it might have been reasonable to expect to sell the “loser” of a fund and put it in something going up. If you would have done that, you would have missed out on the next years’ huge 61.6% return. Again, at that point, realizing your mistake, you might have decided to get back in at the higher price to be exposed to this great investment. However, you would have then been sorely disappointed with three consecutive years of negative returns, then followed by the recent spectacular performance of the fund. Even though the fund had its dog years, its overall ten year annualized return was 14.46%. This return came with only one caveat… you had to stay invested at all times.

The above example is not an isolated case. I could go through every fund in our recommended portfolios and have a similar illustration. The funds we recommend are based on their assets classes, tax efficiency, low expense ratios, their overall correlation with each other, and other factors. These criteria are what we monitor for change and base our buying and selling decisions on.

During volatile market times, we all toy with the thought of selling our holdings based on recent performance. However, we must take an objective approach and leave our emotions out of it. I want to leave you with two recent exerts. The first one is from Meir Statman, a professor of finance at California's Santa Clara University, specializing in the study of investor behavior, and the second from legendary investor Warren Buffett:

"Right now, we just feel like idiots, because it looks so obvious today that anybody with at least one eye would have seen that you should have taken your money out in October of last year. And what we think we see right now, is that these problems will last, and that maybe we can do better by being out of the market, at least until it becomes obvious to our eyes again that happy days are back again. The problem is that what looks obvious now wasn't so clear last October. And we probably will know the best move to make right now in about a year or so too." -- Meir Statman

"THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary." "So ... I've been buying…” "Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now." -- Warren Buffett, New York Times, October 16, 2008

Your staying invested advisor,

Daniel Meek