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Mutual Funds

Breaking Up Is Hard to Do

Five reasons to sell a fund -- and why it's good for your wealth.

Think of that attic or garage crammed with stuff that, for whatever reason, you can't bear to part with. Your mutual fund portfolio may be a similar mess. The difference is, your home clutter is merely a fire hazard, but a poorly pruned portfolio can cost you real money. As much as you hate to trim back the number of shares or toss funds completely that you've become as fond of as your children (maybe more fond of -- when was the last time a kid mailed you a dividend check?), you know there comes a time to let them go. Here are the five main reasons to sell.

1. Lack of balance

Remember the kid who was your perfect seesaw match? Rising to the apex took the merest push of your Keds on the playground sawdust. Keeping your portfolio properly balanced among many investments will also ensure that it rises smoothly.

Success is a prime reason portfolio balance gets out of whack. Say small-company stocks go gangbusters for a couple of years and your small-company stock fund rises from 20% of your portfolio to 40%. It's past time to trim it back and move the proceeds into your other funds. You should rebalance once a year because you don't want one type of investment dominating and increasing the portfolio's volatility. Rebalancing also means your other investments will have the proper amount of assets when it's their turn to have a big year.

2. Fund overload

You buy mutual funds to avoid the hassle of buying dozens of stocks. But buying many funds to cover one type of investment is overkill and just a different kind of hassle. You don't need five funds that invest in large companies, for example. If you are in this situation, pick the one or two funds with the best performance in a category and sell the rest. Owning too many funds gives the illusion that you're diversified, when, in fact, the funds own many of the same stocks. Also, owning too many funds may be a symptom of "decision regret" -— not being able to part with a fund because selling would mean admitting you made a mistake in buying a fund to begin with. Better to suck it up and cut your portfolio to a manageable number of funds.

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3. Lousy performance

By lousy, we mean a fund has to be consistently lousy and relatively lousy. Unless both these conditions are met, a fund may be worth keeping. For example, 2002 was not a good year for T. Rowe Price Small Cap Stock fund, which dropped 14%. But considering that the Russell 2000 index of small-company stocks lost 20% that year, the T. Rowe fund performed relatively well. Judge all your funds by their performance relative to the appropriate index.

T. Rowe Price Small Cap Stock did have a relatively lousy year in 2003, rising 32% when the index rose 47%. However, in most years the fund beats the index, and on an annualized basis it has returned a couple of percentage points more than the index in the past ten years. But if a fund has lost significantly more than the index for two or three years running, look for greener pastures.

4. A new captain at the helm

If your favorite chef or mechanic found new employment, you'd take your appetite or your car, respectively, to his or her new place of business. Likewise, at many funds there is often one inspired individual who is responsible for a fund's performance. When that fund manager leaves, don't automatically cut and run. But take a little time to evaluate whether you should stay in the fund. If the new manager is a complete unknown and the manager you had grown to trust is moving to a similar fund, abandon ship and switch funds. On the other hand, if a fund is managed by committee, as is the case with funds in the successful Dodge Cox family, stay put when there are staff changes.

5. Bloated assets

There's a reason 300-pound linemen don't do double duty as wide receivers. It's tough to be quick and nimble carrying so much weight. In the same way, mutual funds can grow so big that the fund manager becomes overwhelmed tracking too many stocks. Plus, the act of buying or selling large blocks of a single stock can affect its price, which hampers a manager's performance.

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How big is too big? That depends on the size of the companies in the fund. Think of small-company funds as wide receivers: You want them relatively small in asset size so they can trade small-company stocks efficiently and so they don't have to own too many companies. If a small-company fund exceeds $1 billion in assets and its performance starts mimicking the performance of an index of small companies, you may want to put your money in a smaller fund.

On the other hand, think of big-company funds as linemen. They can be big and operate well. But if a big-company fund crosses the $10 billion in assets mark, check for weak performance or index-like tendencies. Some funds continue to be stellar performers after crossing these thresholds, so don't automatically drop fat funds.