Why Fund Holders Are Sitting Tight

Stock fund investors have had some teeth punched out, but most aren't giving in. You might wonder why.

Ten grand invested in the average tech fund a year ago is worth about $4,000 today. Now that stocks aren't making them rich, investors are feeling less loyal than they once did: Outflows from stock funds outpaced investments by a record $29.5 billion last month.

But surprisingly, the outflows are attributable more to a dearth of new investments than to a wave of fundholder selling. Are long-term investors making the right choice by hanging on? And is there a method to this madness?

"People say you should buy and hold, but you shouldn't do so blindly," says Bryan Olson, a director at Charles Schwab's Center for Investment Research. "You shouldn't hold just for the sake of holding on."

Bet With Your Head Steps to building a better portfolio

Identify Losers and Reap Tax Benefits: If a fund is in the red since you bought it and trails its peers over the past one, three and five years, sell it. Don't Fall for What's Hot: Build a diversified portfolio -- it will let you participate in the market with less risk. Here's how you can. Build a Cushion: Keep cash on hand to cover three to six months' expenses in the bank or a money market account. Use Tax-Deferred Accounts: Your 401(k) account or IRA can help you cut taxes now and pave the way for tax-deferred growth over time.

Source: Detox

Since the tech-laden Nasdaq Composite peaked on March 10, 2000, it has fallen a jaw-dropping 67%; many tech-stuffed growth funds have suffered similarly. The $14.4 billion (JAVLX Quote)Janus Twenty fund, for instance, has lost more than half its value since the Nasdaq's peak.

In the face of such a rout, many observers would have predicted a mass exodus from stock funds. But that hasn't really panned out, according to data from the Investment Company Institute, the fund industry's largest trade group. Third-quarter redemptions from stock funds actually fell from their year-ago level, to $302 billion from $372 billion last year. Of course, stock-fund investments fell far more steeply, plunging to $266.3 billion from $430.4 billion a year earlier.

But contrary to what you might think, fund investors don't typically have a hair trigger. There are a couple of reasons they might be holding on now.

One is that many investors put money in stock funds that they don't plan on using for at least 10 years. Most stock-fund shares are held in tax-deferred retirement accounts like 401(k)s and individual retirement accounts.

"I think people have been schooled for years now that investing is a long-term thing and it has finally sunk in," says Phil Edwards, director of the global funds research unit at Standard & Poor's. "A lot of this money is out of sight, out of mind."

Investors might still be sinking 5% or 10% of every paycheck into stock funds, but aren't writing many or any checks to stock funds in standard or nonretirement accounts. It's hard to blame them for feeling like they have enough, if not too much, exposure to stock funds. In 1980 just 5.7% of U.S. households owned mutual funds, but by the end of last year half of households owned fund shares, according to the ICI.

Another reason for fund investors' fortitude has less to do with sound reasoning and more to do with emotion. With so many investors seeing their invested dollar turned into 50 cents, many might be hoping things can't get worse or crossing their fingers for a big rebound. Just realize that you need a 100% gain to break even after a 50% loss.

Not Much Coming Through the Door Less money is going into funds, but less is leaving too

Source: Investment Company Institute

"When people experience huge losses, they think it would be stupid to sell now because it can't get much worse," says Scott Cooley, a senior fund analyst at Morningstar. "Then you think of people who own the (JAMFX Quote)Jacob Internet fund." People who bought at its Dec. 13, 1999, inception have lost 92% of their money, Cooley notes.

Others might simply be in shock. Losses like that and the absence of any alternative, with nearly every stock-fund category under water, can also stun investors into standing pat.

"There's definitely a psychological barrier when you see big losses," says Schwab's Olson. "Some people just don't want to admit they have a big loser and sell."