How do you know when it is time to sell a failing fund?

We explain how investors can tell whether an investment fund is temporarily or permanently out of form. 

The most recent bout of market volatility created by the Covid-19 pandemic will have caused many investors to re-evaluate their portfolios and to ask the all-important question: is it time to sell out of a disappointing investment?

While it is never easy to admit defeat, timing the sale of an investment is just as important as buying at the right price. And this is something all investors struggle with – even professionals with years of experience.

A research paper published last year analysed the daily trades of institutional fund managers between 2000 and 2016, and found that significantly more time was devoted to buying investments than selling. Authors Klakow Akepanidtaworn, Rick Di Mascio, Alex Imas and Lawrence Schmidt concluded that professional investors displayed skill when buying in, but made poor decisions when selling out – and this ultimately impacted performance.

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“There is a bias for people to cut their winners and hold on to their losers. This is a psychological bias that is engrained because people don’t want to lock in or crystallise a loss,” explains Nathan Sweeney, a senior investment manager at Architas.

However, there is much to be said for cutting your losers and letting your winners run: a study produced by Hendrik Bessembinder in 2017 showed that just 86 stocks were responsible for half of the $32 trillion net wealth created on the US stock market between 1926 and 2015.

“If you are a stock-picker and you found a winner, resist the temptation to sell it. The odds that your next pick will be a winner are worse than the flip of a coin. So, please, let your winners run, cut your losses and use that money to pick another stock,” notes Joachim Klement, an independent investment strategist and blogger.

Time to cut your losers

So how can investors resist the temptation to hold on to a disappointing investment for too long?

The starting point is to consider why the investment has not performed in line with your expectations. To help you to answer this question there is an easy step that can be taken at the outset: write down your rationale for buying in – and revisit it frequently.

“You need to remind yourself why you own something in the first place and decide whether this has changed,” explains Simon Brazier, manager of the Ninety One UK Alpha fund. Brazier will only buy into a stock that he would feel comfortable buying more of if it were to fall 20%. In his view, this underscores the importance of really doing your homework before buying in so that you don’t get spooked if the share price falls.

There are numerous reasons why an investment can go wrong. If you have invested in a stock or fund, you may have identified a catalyst with the potential to improve performance.

As time passes, you will need to assess whether the catalyst has failed to materialise or is simply taking longer than you anticipated.

Second, an unforeseeable event can take place which fundamentally changes the investment case, such as the shock departure of a well-known fund manager, or a global pandemic. Third, you may have been let down by the management of a company or fund, for example if they have been over-optimistic in their communications or failed to execute their strategy.

Finally, did you buy in at the wrong price or time? “The most crucial thing about the outcome for return is when you bought in. Often you can buy a good company at the wrong valuation,” says Brazier. In this instance, it might be time to consider whether there are better investment opportunities elsewhere.

Fighting FOMO

Daniel Lockyer, a senior fund manager at Hawksmoor Investment Management, says it is crucial to clarify what you are measuring the performance of an investment against.

With this in mind, he warns investors not to “get sucked into FOMO (fear of missing out)” when assessing underlying investments. “You don’t necessarily need to switch horses and go into the number-one performing fund purely because that is performing better. If the fund you hold is doing a good job for you, growing your wealth and giving you a good income, that should be sufficient,” he explains.

Sweeney stresses the importance of reviewing the performance of underlying investments regularly, flagging those that are lagging the market or benchmark as early as possible. “You should look at your winners and losers, and try to investigate why a losing position is costing you money or not working at this time.”

For example, a fund manager might lag the benchmark because their style is out of fashion. But if you understand why they are underperforming, have conviction in their portfolio and believe they can bounce back, then you may wish to be patient.

However, it is a different matter if poor performance cannot easily be explained and the fund isn’t fulfilling what you bought it to do. This could be down to the fund manager drifting from their original objective, allowing their style or process to change over time. “If an investment you have is no longer performing the role you bought it for – for example, an absolute return fund doesn’t come good when you most need it – then you have to ask why you own it,” Lockyer says. This is particularly relevant if you have other potential investments on the subs bench which look more attractive and could be a better fit for your portfolio over the long run.

“Don’t be afraid to sell something. It doesn’t mean you are out of it forever, it just means you are out of it at that point in time and you have taken risk off the table. And then if your view changes, you can always buy it back,” he adds. As soon as an investment is flagged as disappointing, he and his team cut the position straight away.

He suggests setting a price you would want to start selling at if the investment does not work out as planned. If you wish to take emotion out of the equation, this can be done by putting a stop-loss order in place with your investment platform or broker, so part or all of your investment is sold automatically if it reaches a certain price.

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Learn from your mistakes

Instead of trying to brush investment failures under the carpet, Premier Miton’s Gervais Williams urges investors to face them head on. “At the end of the day, you have to take responsibility for every failure: think back and say, ‘what could I have done differently that would have alerted me to those risks ahead of time?’ You can learn a lot from the failures. They are part of the investment process.”

Lockyer echoes these sentiments. In his opinion, losses ultimately help us to develop and grow as investors. “The worst you can lose from an investment is 100%, but there is no limit to the upside you can earn. So don’t be afraid to lose money in

Five red flags for stock investors

Gervais Williams looks for any of the following five sell signals when he assesses stocks:

- Falling sales.
- Declining margins.
- A management team which looks over-stretched.
- Question marks over the company’s balance sheet – for example if cash is running low.
- Extraordinarily high expectations for the business, which means there is potential for disappointment.