Why I Sold My Mutual Funds

In my post titled Six Investment Pitfalls I commented:

Yep, I've done all of these in my lifetime. Early on in my investing career, when I knew little about the subject and thought I could pick killer stocks better than anyone on the planet, I did all of these -- several times. Then, when I learned a bit more, I became somewhat smarter, but didn't quite get all the facts right again. Now I have some mutual funds that I should have never been in (and want to get out of) but yet have huge capital gains tax implications if I sell them. Making bad decisions early on can certainly have long-term consequences. Hopefully, someone can learn from my mistakes.

Let me add a bit more detail to this.

After I figured out that I wasn't a stock-picking pro (10 to 15 years ago), I decided that I'd invest in mutual funds instead. But I 1) didn't have a strategy and 2) didn't know how important it was to control investing costs. So I picked a NUMBER of funds here and there in various accounts -- taxable accounts, IRA for my wife, and an IRA for me (rolled over from a 401k). In fact, I never met a mutual fund I didn't like. I ended up with somewhere around 40 different funds in three accounts.

I eventually realized that this was foolhardy (investing without a strategy) and I studied the topic a bit more. That's when I decided index funds were for me and I developed a strategy around investing in them. That was several years ago and since that time index funds have become the mainstay of my portfolio.

But I still had the other 40 funds. When I moved over to index fund investing, I simply started new funds -- I didn't sell the old ones. So I ended up with money in a wide number of funds I didn't really want. So I could have simply sold them, right? Not unless I wanted a big capital gains tax hit. After all those years, the funds had made some decent gains, so if I sold them all at once, I'd have a hefty tax bill.

Of course I could have sold them when I sold loser funds/stocks (then the gains would be offset by other investment losses), but I didn't have any losers because I was never selling. So I ended up with a huge number of funds that were difficult to track and manage.

That's when a reader suggested that I give away my appreciated mutual funds. If I gave them directly to a charitable organization, I could avoid the capital gains tax altogether (for more info on this, see How Shrewd Investors Save on Taxes.) So this is what I did in 2007 and the first half of 2008. I gave mutual fund shares directly to my favorite charities. I then took the amount I would have given in cash during normal times and invested that in index funds. This got rid of several funds in a couple years, but I still had a long road to go (BTW, in case you're interested, I gave a boatload away in early 2008 -- enough to cover my giving for the whole year -- so I got a good amount of value from some of these funds before the market tanked.)

Then the market crashed big-time. In the span of a few weeks, my capital gains were eroded and I had losses. Now I didn't need to wait to sell all the funds I owned, so I sold them all and invested the proceeds into the following index funds:

• Vanguard Total Stock Market Index (VTSMX)
• Vanguard Total Bond Market Index (VBMFX)
• Vanguard Total International Stock Index (VGTSX)

Of course I would have preferred that the market stayed high and I would have gotten myself out of the funds as originally planned, but I'm trying to make lemonade out of lemons here. At least my investments will be much simpler to manage in the future and will reflect the strategy I want them too. Then again, they'll be easier to manage because they're a lot lower in value too. :-(

For additional perspective, check out this piece from the Wall Street Journal on getting a portfolio do-over.

Comments

[Miss M]

I can see myself in your shoes in a few years. Between two 401k's, ETf's and mutual funds I've got between 20 and 30 funds, do I really need all those. Is there a simpler strategy I can use. I admit I don't fully understand investing and am now educating myself to be a better investor. I'm not going to make any moves until I have a better idea of what I'm doing. I hadn't considered the donate to charity option, of course right now I don't have any gains to worry about...

[ekrabs]

That's a great story! Thanks for sharing.

By the selection of these funds, I'm assuming that you are manually setting your own asset allocation right? Because, otherwise, you could just stick to a Target Retirement Fund and call it a day.

[FMF]

ekrabs --

Yes, I'm manually doing it. I'll give more details on what I'm doing exactly as I sort through the issues associated with my portfolio reorganization, so stay tuned.

[PW]

FMF,
You actually picked three good funds that should fair well in the future. Honestly if you took a microscope and looked at all the stocks in certain mutual funds they will almost mirror these three. Morningstar has a great X-ray tool that lets you plug in all of your funds and shows you if you have duplicate coverage anywhere.

Also, not that your interested but William J Oneal has IMO the best book on stock investing, "How to Make Money in Stocks". I'm the most unlikely person to be a stock investor and I am not even that smart :) but I have found that picking killer stocks is not that hard if you have the right education.

[kitty]

I understand your logic about not wanting to pick stock and preferring index funds to value even if I may not always agree.

But... what is your logic for using a bond fund instead of individual bonds? There is a big difference between bonds and stocks which provide an advantage for individual bonds over bond funds: a) if you hold a bond to maturity then you get back your principal unless the company goes bankrupt - the risk you can minimize by sticking to higher rated bonds in well-known companies or just to AA and AAA municipal bonds of larger municipalities. You cannot hold a bond fund to maturity so your return is tied to bonds values on secondary market which can drop a lot if interest rates start going up. Hence you are more likely to lose money in a bond fund than individual bonds. b) a bond fund you mentioned includes a wide range of bonds, including BBB bonds. Do you really want those? c) A bond fund sells and buys bonds throughout which can add to value fluctuation and make you pay taxes on capital gains distributions.

The main thing though is the ability to hold individual bonds to maturity which is missing entirely with bond funds. Sure you have less exposure to the default in individual bonds - a pretty low risk if you stick to higher quality bonds - but you have no option at all of holding to maturity. If the interest rates go up, your bond fund value will go down a lot. With individual bonds you wouldn't care as you could simply held them to maturity and collected interest.

[rwh]

I still don't understand why you were so worried about the capital gains. It's only 15%, you sell the funds and put back 15% to pay the tax next year. Of course, with 40 funds that's a lot of paperwork, but TurboTax can handle it pretty easily.

Now you have no profit (or less profit, you didn't specify). And you have less to give away, if that is still your choice.

I don't want to be overly critical, but you never really explained why you had such an issue with capital gains. Right about now I would be thrilled to have the opportunity to pay the capital gains tax.

[FMF]

Kitty --

Same reason I invest in stock funds versus individual stocks -- they're a better deal for me when you look at all the factors -- time, expertise, ease of management (in one account), risk, hassle, etc. My time is pretty valuable and I assign a "cost of investing" to anything that requires more than the minimum time. Subtract that from individual bonds and any advantage they have goes away.

RWH --

1. 15% of a large number is a large number. Didn't want to pay that much tax.

2. Sure, it's easy to look back now and say "if you'd sold them then you would have had more", but who knew the market would be down so much in a couple months? No one could have predicted this. (And if anyone says they could/did, my next response is "congratulations on being a billionaire" because you HAD to have made a fortune selling short.)

[FMF]

RWH --

Also to add, it's not like I would have "saved" the money if I had sold and then reinvested in other funds as those funds went down now. At least I don't now have to pay capital gains taxes on top of losing in the market (which I would have done anyway when I reinvested.) And I didn't give more away earlier since I gave away enough in the first part of the year to cover my annual giving.

[rwh]

FMF: You're position on not wanting to sell and take a profit (because as you said, who new the market would fall and reinvested gains would have just lost money anyway) is completely illogical. It's like not wanting a raise at work because you'll have to pay more FICA and income tax. By your logic we should never sell for a profit because we would have to pay the CG tax, therefore we should never invest in the first place; just spend it now or stuff it in a mattress.

And come on, 15% of a large number is still a large number? What's the other 85%, chopped liver? You could never pay Spock or Data on Star Trek.

[FMF]

RWH --

There wasn't a substantial difference between the funds I was selling and the ones I was buying (a bit on the margin, but not that noticable.) My change was mainly for ease of management purposes. Given this, there was really no compelling reason to sell all at once and incur a big tax liability.

[S]

I just opened up a Vanguard Target Retirement Fund 2050 yesterday... Is that considered a mutual fund? Is it too late to change it?

I was going to start off with a 3000 in the Vanguard Total Stock Market Index (VTSMX) but I thought not knowing enough .. picking the Retirement Fund would be better...

any advice?

[Grreg Retzloff]

OK, FMF:

First, read Roger Gibson's "Asset Allocation."

Then, if you like three funds, consider this. Pick a Vanguard target-date fund appropriate to your age and investment time horizon. This is your "core," and will be about 75% of your holdings. Add about 10% Vanguard REIT Index (VGSIX), 5% PIMCO Commodity Real Return (PCRDX), 10% Vanguard Short-Term-Treasury Index (VFISX). Why? This diversification should both enhance your portfolio's returns and lower your portfolio's volatility over the long haul. Check this out with Morningstar's Portfolio Manager.

To rwh: Beleive me, if you were actually in a position to pay capital gains tax, you would not be thrilled!

[Michael Martin]

Are there any incentive or referral programs to join Vanguard as Im looking to buy into their Index funds?

Also, am I correct in that if I put 10K into one fund then I wont have to pay any annual fees - or what is your recommendation to lower fees paid.

Thank You

[FMF]

S --

Yes, that's a good fund.

Greg (and others) --

A few points I need to clarify:

1. The changes I made do not reflect ALL of my investments. These are just the current moves I've made. My asset allocation is broader than three funds (maybe a future post?)

2. In addition to point #1, I do not have equal amounts in the three funds noted above.

3. I do not got with the Target Retirement funds because: 1. While they are low cost, I can get cheaper funds (a post on that is coming up in a couple weeks, but let me just say "Admiral shares".) 2. I prefer to know my exact mix and manage my asset allocation and the funds above allow me to do this.

Michael --

I don't think there are any referral programs, but thanks for asking.

As far as costs, etc. I suggest you call Vanguard. They are very helpful.

[S]

So sticking with the 2050 is ok? Should my future investments be more geared towards the total stock market index.

Question: In Jan 09, if I put $3000 into a index fund. Can I use the $2000 I have left over from the 2008 (5k max) and put that into the index fund? and still have another 2000 (for 2009) to put into the index fund as well?

I know that I have until APril of 2009 to invest into 2008.

I wasn't sure if the correct terminology to say what I said above... I hope its clear

[FMF]

S --

It's impossible for anyone to say what a "good" investment is for you without knowing your circumstances, goals, etc. But that fund is a "good" one in the sense that it's a low cost, easy way to achieve a broad-based portfolio.

[rwh]

Grreg Retzloff:

I just sold some greatly appreciated stock in order to pay moving expenses. It was preferred stock that I've owned for 30 years and believe it or not, it has continued to appreciate in the few weeks since I sold it. It was a planned sale, and I also sold some other (inherited) stock that had dropped in value slightly from the date I received it. I will offset some of my gain with a loss. But I will still have a taxable gain. And in this market I am thrilled to have it.

I'm not at all concerned about paying a capital gains tax, just as I'm not concerned I sold some stock that is still rising and sold some other stock that has fallen, therefore locking in a loss. I don't have a crystal ball and can just make myself crazy worrying about stuff like that.

By all means I try to minimize my tax bill, but not selling appreciated assets for the sole reason of not wanting to pay a capital gains tax deprives me of the use of far more of my money than the government does through taxation.

"Same reason I invest in stock funds versus individual stocks -- they're a better deal for me when you look at all the factors -- time, expertise, ease of management (in one account), risk, hassle, etc. "

Time is an important issue which I understand. Same about hustle - although bonds don't require quite the same commitment as stocks.

However, in terms of risk, bond funds can be riskier than individual bonds. You gain diversification, but you lose a chance to hold your bond to maturity. Also, all bonds lose value when interest rates go up. With individual bonds you can ignore the fluctuations, collect your fixed interest and wait till maturity. Sure, you'll be earning less interest than newer bonds, but you'll still get your principal back. Not so with bond funds. Sure the fund can compensate by reinvesting money from the bonds that mature earlier into those with higher yields, but you may have to wait longer to recoup the losses.

Bonds aren't stocks. Buying a stock fund is the same as buying a lot of stocks at once. Buying a bond fund is not at all the same as buying a lot of bonds. Bonds are fixed-income investments. Bond funds aren't.

Certainly there may be case for buying bond funds (like not having enough money since in most cases 5K is minimum for each bond), but it's important not to think of bond funds as equivalent of many individual bonds. These are different investments.

[LotharBot]

FMF,

I know you would've liked to "sell high"... but if you had, you'd have also been buying high. You're selling your mutual funds at a loss right now, but you're also buying into a market that's lost equally much, so you're getting the same number of Vanguard shares (or whatever) as you would've if you sold high and bought immediately.