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Know When to Fold ’Em

Once you own a fund, how can you tell when it’s time to sell? The standard advice is to ditch a fund if it underperforms the market (or similar portfolios) for one—or is it two?—or is it three?—years in a row. But this advice makes no sense. From its birth in 1970 through 1999, the Sequoia Fund underperformed the S & P 500 index in 12 out of its 29 years—or more than 41% of the time. Yet Sequoia gained more than 12,500% over that period, versus 4,900% for the index.14

The performance of most funds falters simply because the type of stocks they prefer temporarily goes out of favor. If you hired a manager to invest in a particular way, why fire him for doing what he promised? By selling when a style of investing is out of fashion, you not only lock in a loss but lock yourself out of the all-but-inevitable recovery. One study showed that mutual-fund investors underperformed their own funds by 4.7 percentage points annually from 1998 through 2001—simply by buying high and selling low.15

So when should you sell? Here a few definite red flags:

a sharp and unexpected change in strategy, such as a “value” fund loading up on technology stocks in 1999 or a “growth” fund buying tons of insurance stocks in 2002;

an increase in expenses, suggesting that the managers are lining their own pockets;

large and frequent tax bills generated by excessive trading;

suddenly erratic returns, as when a formerly conservative fund generates a big loss (or even produces a giant gain).

WHY WE LOVE OUR OUIJA BOARDS

Believing—or even just hoping—that we can pick the best funds of the future makes us feel better. It gives us the pleasing sensation that we are in charge of our own investment destiny. This “I’m-in-control-here” feeling is part of the human condition; it’s what psychologists call overconfidence. Here are just a few examples of how it works:

In 1999, Money Magazine asked more than 500 people whether their portfolios had beaten the market. One in four said yes. When asked to specify their returns, however, 80% of those investors reported gains lower than the market’s. (Four percent had no idea how much their portfolios rose—but were sure they had beaten the market anyway!)

A Swedish study asked drivers who had been in severe car crashes to rate their own skills behind the wheel. These people—including some the police had found responsible for the accidents and others who had been so badly injured that they answered the survey from their hospital beds—insisted they were better-than-average drivers.

In a poll taken in late 2000, Time and CNN asked more than 1,000 likely voters whether they thought they were in the top 1% of the population by income. Nineteen percent placed themselves among the richest 1% of Americans.

In late 1997, a survey of 750 investors found that 74% believed their mutual-fund holdings would “consistently beat the Standard & Poor’s 500 each year”—even though most funds fail to beat the S & P 500 in the long run and many fail to beat it in any year.1

While this kind of optimism is a normal sign of a healthy psyche, that doesn’t make it good investment policy. It makes sense to believe you can predict something only if it actually is predictable. Unless you are realistic, your quest for self-esteem will end up in self-defeat.

As the investment consultant Charles Ellis puts it, “If you’re not prepared to stay married, you shouldn’t get married.”16 Fund investing is no different. If you’re not prepared to stick with a fund through at least three lean years, you shouldn’t buy it in the first place. Patience is the fund investor’s single most powerful ally.

Chapter 10

The Investor and His Advisers

The investment of money in securities is unique among business operations in that it is almost always based in some degree on advice received from others. The great bulk of investors are amateurs. Naturally they feel that in choosing their securities they can profit