One of my basic philosophies is that investing takes patience. There are a lot of things in life that we want right now, and we like to see instant results. But investing success doesn't happen overnight. It takes time and patience. A well-allocated, diversified investment strategy works over time because it helps investors stick to their investment plan during periods of volatility and declines in the market.
Another one of my philosophies is that you can add value to your investments by owning actively-managed funds. The name of the manager who's making the buy, sell, and hold decisions every day and their performance over different time periods matters much more than the name of the fund.
A recent study by Robert W. Baird & Co. showed these two factors to be essential to investing success. The study analyzed more than 500 mutual fund managers who consistently beat their benchmarks by at least one percentage point on a 10-year annualized basis. It found that even the best fund managers can fall behind the market at some point. Of the managers who beat their benchmarks by at least 1 percentage point on a 10-year annualized basis, nearly 400 had at least one 12-month stretch when they underperformed the benchmark by 10 percent or more.
Looking at a longer period of three years, the Baird study found that more than half the managers underperformed their benchmarks by at least 3 percent annualized during the 10-year period ended Dec. 31, 2007.
The point is even the most successful managers can have bad periods sometimes. That doesn't mean you have to sell the fund. Good managers tend to have bursts of performance. They're trying to identify companies that are really good values, and it can take the market longer to recognize values that the manager sees. It often takes six months to a year for the market to recognize values that the manager finds.
That's why investors have to be patient. Many investors tend to make mistakes when they react to a manager's short-term underperformance or changes in star ratings. Baird's study found that when Morningstar upgraded funds with more stars, the funds attracted more money and actually underperformed the downgraded funds after that. Investors pulled money from the downgraded funds and missed the outperformance of the funds afterwards.
Try to avoid jumping around from fund to fund just because of bad short-term performance or changes in star ratings. Many people try to time the market and get attracted to a sector or fund that has already risen, so they buy when the price is high and sell when the price is low. This is how investors lose money.
On the other hand, you don't want to buy and hold and then forget about your funds. Monitor your funds regularly to make sure the manager is staying on track. A fund's performance depends on a lot of factors, including the manager's investing philosophy and their daily buy, sell, and hold decisions. Any one factor change can affect a fund's performance. A top analyst might leave the fund. Or perhaps the fund manager moves to another company or retires.
If a change alters the fund in a big way, it could be enough for you to consider whether you want to keep holding the fund. The good thing is, if one of your funds doesn't meet your expectations, others are readily available to take its place.
When a fund underperforms, one of the hardest things to do is deciding if a good manager has gone bad or the manager is just having a bad stretch and can turn things around. It's a tough decision. We spend a lot of time talking to fund managers and analyzing many different factors when a fund has underperformed for a long period of time.
If you decide to sell a fund and look for a replacement, don't chase the hot sector or hot funds. Instead, find the best managers. I'm not lucky enough to recommend the best funds every day, week, and month. In the business of managing mutual funds—just like in every other industry—some people are better at it than others. When you're patient and stick with a buy and hold strategy, the funds with the best managers will pay off in the long run.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center®, an SEC-registered investment adviser which provides research and mutual fund and asset allocation recommendations to stores in The Mutual Fund Store system.
Clarified on 05/24/11: This article has been updated to show that both downgraded and upgraded funds in the study outperformed their peers, but downgraded funds performed better.