"You Got to Know When to Fold 'Em"

That well-known investment philosopher Kenny Rogers said volumes when he sang the chorus: "You got to know when to hold 'em, know when to fold 'em, know when to walk away, know when to run. . . . the secret to survival is knowin' what to throw away and knowin' what to keep."

Most investors will admit that reaching a decision on when to sell a fund is almost as daunting as deciding what to buy in the first place. The process is made more difficult by three personal fears that can paralyze us.

• Fear of regret. You "just know" that as soon as you unload the dead wood, it will magically spring back to life. After holding it at a loss through thick and thin, you'll watch glumly from the sidelines as your former holdings soar! This is an irrational kind of paranoia, but because it does happen occasionally, it looms large in our thinking.

• Fear of failure. There's also the fear that, having sold the laggards, you'll make a mistake when selecting replacements. How do you know you'll be better off? You don't. What if the replacements do poorly? You might end up worse off than if you'd taken no action at all.

• Fear of embarrassment. Will your husband or wife be critical if your changes don't work out as planned? What about your friends at work, the ones you like to share 401(k) investing ideas with? Will they talk about your "bad" decision behind your back? Or your broker, who may be advising you to "give it a little longer"—will he think less of you?

Let's look at four primary reasons for selling, and see how we can approach the decision-making process in an objective way that neutralizes our fears and frees us to take timely and appropriate action.

1. SELL WHEN YOU WANT TO CHANGE YOUR ASSET ALLOCATION

Your "asset allocation" (also called "portfolio mix") refers to the way you divide your money among several different classes of investments. The term is most commonly used in reference to the percentage of your portfolio that you invest in stocks versus interest-earning investments like money market funds and bonds. Four examples, ranging from a 100% stock portfolio (highest risk) to a portfolio invested 40% in stocks and 60% in bonds (lower risk), are shown each month in SMI's "Easy As 1-2-3" explanation . Asset allocation can also refer to the way you subdivide your money further among various stock and bond categories. The percentages shown on the "Easy As 1-2-3" page are merely our recommendations for 2005. We change them every January to reflect the market conditions expected for the coming year. There's nothing magic about our suggestions; other market professionals will have their own percentages that reflect their view as to what is appropriate.

Ultimately, you will be the one to decide on a portfolio mix that seems best given your age, goals, and risk tolerance. Commonly, investors move in the direction of lower risk (i.e., a smaller amount allocated to stocks) as they advance in age or achieve their financial goals. When this happens, you will need to sell some stock holdings and invest the proceeds in interest-earning securities.

2. SELL WHEN YOUR FUND NO LONGER FILLS ITS ASSIGNED ROLE

When you purchase a fund, you expect it to invest in a certain class of asset (growth companies, for example). Occasionally, due to market conditions or an influx of new money to invest, a fund manager will slowly begin to compromise his original strategy in order to accommodate the situation. If this continues long enough, you'll find that he's no longer filling the role for which you purchased the fund in the first place. For example, it was observed during the tech boom of the late 1990s that many value managers began adding high growth dot.com companies to their portfolios to spice up their performance. This is called "style drift."

Or, it could be that the tools used by analysts like Morningstar are refined, and a fund changes categories due to new guidelines being implemented rather than actual style drift on the part of the manager. In either event, your holdings may no longer reflect the portfolio mix you were aiming for and a fund has to be sold to remedy the problem.

3. SELL WHEN YOU'VE GOT A COMPELLING TAX REASON

Sometimes it's advisable to sell a fund solely for the tax benefits. Usually this means selling a fund in which you have a loss. The loss can be used to offset capital gains $1 for $1, or can be used to shelter up to $3,000 per year in ordinary income. On the other hand, if you're experiencing a low income year, you might wish to sell a fund in which you have a profit in order to move the tax liability forward into the current year when your effective tax rate is lower than usual. On rare occasions, you might wish to sell a fund to avoid an unusually large capital gains distribution scheduled for year-end.

4. SELL WHEN YOUR FUND IS PERFORMING POORLY

As our economy continually moves through its growth-recession-growth cycle, the earnings prospects of companies are affected in different ways. Some are relatively "recession-proof" while others suffer considerable losses in sales and earnings. That's one reason the performance leaders (and the funds that invest in them) change from year to year. As your various portfolio holdings begin to falter, as they inevitably will, you need to sell the laggards and replace them with the new leaders. This is what SMI's Upgrading strategy is designed to do for you automatically.

This seems like common sense. Why doesn't everyone routinely clean out their poor performers? In large part, I believe it's due to the fears I mentioned at the outset. To postpone making a difficult decision, we've become very good at justifying our inaction. Perhaps the most common is: "I'll sell as soon as my fund gets back up to what I paid for it." But if that doesn't happen, we have no backup plan. Instead, we try to remain optimistic and hope for the best. Have you ever said to yourself:

• "This fund did great in 2003; it'll do great again some day."
• "The fund manager was upbeat in the semi-annual report."
• "Morningstar still gives it four stars!"
• "I'm too busy to research new funds, so I'd better just keep what I have."
• "I've made good money with this fund; I'm still ahead even after the recent weakness."

This kind of thinking explains why investors have left $489 billion in the ten largest U.S. stock funds, only three of which currently rank in the top quartile of their peer group (according to the SMI performance ranking system). Those three leaders have $130 billion in assets, meaning there's $359 billion languishing in the seven others. It's so important to have a selling strategy to nudge you out the door when a fund you own underperforms.

UPGRADING AUTOMATICALLY REPOSITIONS YOU FOR CHANGING MARKETS

The SMI Upgrading strategy based on performance momentum is an excellent discipline that will help you overcome your inertia. Consider this illustration of how upgrading repositioned our model portfolios into more aggressive holdings, automatically, when the last bear market ended.

As the market was bottoming in late 2002, SMI's Upgrading strategy was emerging from the ravages of the bear market in relatively good condition. Our all-stock portfolios had slipped only 12.7% over the three-year period 2000-2002; during the same period, the overall market as measured by the Wilshire 5000 was down a wrenching 37.3%.

Then, as the new bull market unfolded, our upgrading methodology weeded out the more defensively-oriented funds in return for ones that would profit much more handsomely from the new market uptrend that was getting started. In 2003, 14 of the 16 U.S. stock funds from the December 2002 lineup were sold. As a result of this structured selling process, the model portfolio turned in exceptional gains over the next two years, climbing 72.0% versus 48.2% for stocks as a whole.

Thanks to the discipline enforced by our Upgrading guidelines, we showed gains of 50.2% for the entire 2000-2004 period at a time when the market overall was losing 7.1%. (Recent year by year performance results for our Upgrading portfolios as well as the overall market can be found on the SMI Performance History page.)

CREATING MY "LAGGARDS LIST"

To encourage you to take a tough minded look at your holdings, I decided to prepare a list of "time to fold 'em" funds, both load and no-load. First, I opened my Morningstar database and instructed the software to retrieve performance information on U.S. and foreign stock funds, but to exclude index funds, "life cycle" funds, very small funds (under $10 million in assets), and funds that didn't have at least a 5-year track record. The result was a listing of more than 2,500 hybrid and stock funds.

Next, I grouped them into their respective risk categories so I could compare apples to apples as I put them through two tests. The first test involved ranking them according to their performance momentum. Momentum is a measure of a fund's performance consistency over the past year. It is the sum of a fund's most recent 3-month, 6-month, and 12-month returns. (For a detailed explanation of why we believe it's a helpful tool, see the "Performance Momentum and SMI's Fund Upgrading Strategy"  bonus report.) All the funds in the top half of each category's rankings "passed" the test; those in the bottom half "failed." Second, because I wanted to include a portion of the 2000-2002 bear market in the process, I ranked all the funds again, this time according to their most recent 5-year performance. As before, I considered those in the top half to have passed and those in the bottom half to have failed.

To make my "Laggards List," a fund had to flunk both tests. In other words, these funds performed in the bottom half of their risk category not only with respect to SMI's momentum calculation which covers the past 12 months, but for the past five years as well. As it turned out, exactly 800 funds earned this dubious distinction. The 100 largest are shown in this table. These are the ones most widely owned by investors, and by extension, investors who have been slow to take action when a fund needs to be sold. (The entire list of 800 is available at the end of this article for our web members.)

TIME FOR A CHANGE?

If I owned any of the funds on this list, I would unload them now. They have been consistent also-rans the past few years, and are imposing high opportunity costs. Consider the returns from those funds that passed both of my two tests (average annual gain of 7.3% over the past 5 years) compared to those that failed both (average annual loss of -3.5%). This represents under-performance of 10.8% each and every year. In a $25,000 account, that's a difference of $14,637. If the same performance gap continued for another five years, the opportunity cost would grow to $33,068!

Investors have a staggering $740 billion in the funds on my "Laggards List." If some of that money is yours, it's time for a change. I'm not saying the current laggards will never shine again. There are many funds on the list that have managers with excellent reputations. Some of them have been on SMI's recommended list in the past. They may indeed return to the ranks of performance leaders down the road, and we'll be happy to own them when they demonstrate they're on top of their game once again. But in the meantime, doesn't it make sense to go with funds that are better positioned for the current market?

You can use this as an opportunity to move to one of our recommended funds  or a highly-ranked fund in our Fund Performance Rankings . One of the advantages of using no-load funds is that changes like this are free and relatively easy to make. If you're in a load fund, you can usually move to another fund within that family at no cost.

Markets and market leaders change continually. It's possible that within the next year or two you'll find some of our current favorites on an updated "Laggards List"! Staying flexible and ready to upgrade your holdings as the performance leaders rotate is the price you pay for better investment returns.

• Full Laggards List - [PDF]  
• Full Laggards List - [Excel]  
• SMI's Upgrading Strategy

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