Remember 2000, when many investors fell flat on their faces as the funds they loved in the late '90s tripped them up during one of the meanest bear markets of all time?
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If you cleaned up your portfolio in 2000 and have ignored it since then, you probably are committing the same mistake that investors made seven years ago: indulging in too much of a good thing. Only your mistake now is probably holding too much of the opposite type of fund that gave you trouble seven years ago.
The recovery since the cruel bear market early this decade has enriched investors who unloaded funds that were hot before the market plunge and bought the exact opposite. The sweethearts of the late '90s, large-cap growth mutual funds, turned ugly in the 2000s. The darlings of the last seven years have been the small-cap value funds no one wanted at the end of the '90s.
According to Russell Investment Group, the index for the small, bargain-priced stocks--the Russell 2000 value index--has easily more than doubled since the end of 1999. Meanwhile, the Russell 1000 growth index--an index for large, fast-growing stocks--remains in negative territory after the crushing blows of 2000 and investor neglect since then. The index is down nearly 30 percent since the end of 1999.
But rather than feeling confident in the funds that have grown your money this decade, you should be thinking about gearing down your bets on the winners and adding to the funds that have been ignored, said Stephen Wood, a portfolio strategist for Russell.
Fund types, or asset classes, tend to run in cycles, with the outstanding categories staying that way for only so long. Although no one knows when a cycle will end, analysts say seven years should start signaling an amber light, especially when performance is so dramatically different between the categories.
"The areas people find attractive are almost always the ones they should find unattractive, and those they find unattractive are probably more attractive," Wood said.
Investors who ignore that tend to get hurt in shifting cycles, he added.
"It's almost like clockwork--the ability of the average investor to hurt themselves," he said.
In the current environment, Wood said, investors probably should be reducing their exposure to mutual funds that invest in value stocks of all sizes, and especially small companies. And they should be moving some of that money into the large, faster-growing stocks.
That's called rebalancing, or periodically moving money from hot categories to cooler, less-popular categories to bring your portfolio back to where you originally intended. The process insulates investors from becoming caught inadvertently in a change in cycles.
With rebalancing, you ride a favorite type of mutual fund only so long, and then you start to prune away some of your exposure. Likewise, you never ignore a type of investment too long. You add some money so you are ready when the next cycle hits.
Because small-cap value funds have been so strong, they probably occupy a much greater portion of your portfolio than you might have intended seven years ago, perhaps 100 percent more than you intended.
Russell analyzed what would have happened to a portfolio constructed thoughtfully in 1999 to reflect the makeup of the stock market and to divide money into 70 percent stocks and 30 percent bonds. The portfolio might be appropriate for investors in their 30s and 40s if they don't become nervous during downturns in the stock market.
Based simply on the moves in large and small stocks and growth and value stocks, Russell identified how out of balance a current portfolio would have become compared with Dec. 31, 1999.
Assuming an investor made no conscious changes in a portfolio since the end of 1999, and simply put money in various Russell indexes and let them run their course, the investor would be far short of the original weighting of large-cap growth funds and small-cap growth funds.
Because returns have been so disappointing, the portion of the portfolio in the large-cap growth funds has shrunk about 50 percent, and the portion in small-cap growth funds has shrunk about 30 percent, according to Russell research.
Meanwhile, the portion in small-cap value funds has climbed nearly 100 percent, potentially leaving the investor vulnerable to a sharp downturn in such investments. The portion in large-cap value funds is also skewed by strong returns, but not nearly as much as small-cap value funds.
If you have money in a 401(k) or individual retirement account, you can shift money easily from one type of fund to another. But if it is in an account that is taxed, the process is more complicated.
If you sell a fund, you may have a capital gain that can reduce your returns.
In a recent study, Mark Riepe, senior vice president of the Schwab Center for Investment Research, ran various portfolios that had been rebalanced monthly, quarterly and annually through historical market simulations.
In the case of taxable accounts, Riepe found that selling investments and buying others to put portfolios back in balance carried tax consequences that undermined performance, especially if investors rebalanced often, such as monthly.
In such a case, he suggested that rather than selling, investors simply invest new money into the asset class where they had become underweighted, or to sell when they could offset gains with losses in some other investment.
He also suggested waiting to sell an asset, if possible, until after it was a year old and would be subject to a maximum 15 percent capital-gains tax rate, rather than a short-term tax rate that could be as high as 35 percent.
In the case of 401(k)'s and IRAs, he found little difference in results whether investors rebalanced quarterly, monthly or annually. But to secure the best results, rebalancing was clearly necessary, he said.
Gail MarksJarvis is a Your Money columnist.