Amid seasick markets and ongoing threats of terrorist attacks, skittish investors may be more inclined than ever to sell their mutual funds. In certain cases, such selling is warranted, financial planners say. But a new report out from Financial Research Corp. shows just how much investors stand to lose by trading their fund holdings.
In the most relevant finding for investors, the firm tried to assign a rough dollar figure to how much those who traded would have lost over time.
Over a 25-year period, the firm estimates that the average investor's $10,000 investment in mutual funds would have grown to $123,000 without any trading, but only $70,000 with trading. The $53,000 difference comes from bad timing.
"It's due to investors buying overvalued investments and ignoring undervalued investments," says Gavin Quill, director of research studies at FRC and the author of the report. "It comes down to chasing performance."
FRC research shows that investors would have earned 10.9% annually if they
dollar-cost averaged over the decade of the 1990s.
Dollar-cost averaging is an investment strategy, designed to reduce volatility, in which securities or mutual funds are bought in fixed-dollar amounts at regular intervals regardless of which direction the market is moving. But looking at returns based on money flowing into and out of funds, FRC found the average investor would have earned only 8.70% annually.
The disparity reflects the fact that many investors dump money into a fund just after a period of market-topping returns and withdraw money before a period of outperformance.
What Investors Say Vs. What They Do
In recent years, trading in funds has accelerated. FRC found that the so-called average holding period for funds fell from 5.5 years in 1996 to 2.9 years by 2000. Even the five-year figure isn't anywhere close to what most financial planners would consider long term -- holding a fund for at least 10 years.
Yet most investors say they follow a buy-and-hold strategy. According to a recent survey by the Investment Company Institute, 83% say they're not overly concerned with short-term market fluctuations.
In other words, what investors think they're doing is not the way they are behaving.
Of course, it's possible that a small number of investors who trade frequently could have somewhat skewed the results of his study, making the holding period appear shorter than it really is, Quill says. But most mutual fund companies won't permit daytradinglike levels of turnover. They typically allow no more than four "round trips" (or moves in and out of a fund) in one year, he says.
Even if his estimate of the average holding period was off as much as 50% -- which he doesn't think likely -- the average period would still be only four years. That's far less than the 10 years he'd consider the minimum standard for a long-term holding. "We still would have painted a definitive picture of investors who are not buying and holding," says Quill.
Know When to Fold 'Em
But that's not to say that investors should never dump funds. Louis P. Stanasolovich, a certified financial planner and founder of Legend Financial Advisors in Pittsburgh, says he recently has been advising some investors to slash their
large-cap growth exposure -- even if it means selling some good funds.
That's because he has seen new clients with investments in as many as six or seven large-cap growth funds, often within the
fund families, that hold overlapping securities. The universe of large-cap stocks is so small that large-cap funds in those families often don't have much choice, he says. And it doesn't make sense for investors to own a bunch of virtually identical funds.
Stanasolovich adds that large-cap stocks may have more room to fall, with some overvalued by as much as 40% or 50% percent. He is counseling clients to put money into funds that aren't closely correlated with the broader market, like bonds, real estate or even short funds (though he wouldn't put more than 3% or 4% of a portfolio in the latter).
But there's at least one silver lining to selling a mutual fund: It can help you cut your tax bill.
Stanasolovich recommends finding the specific "tax lots" within mutual funds that have lost money since you bought them. In other words, if you've bought into a fund at various different prices over time, find the specific investments that have subsequently lost money. Then sell those lots before the fund declares its year-end capital gains distributions so you can avoid paying additional taxes.
You can apply up to $3,000 from those fund losses to offset other income from wages, dividends or interest.