Fund investing: How the mighty have fallen — but that's OK

When a certain mutual fund does especially well for you during a particular market season, it's easy to fall in love and hold on to that fund forever (or at least much longer than you otherwise would, absent the initial success). That can be a big mistake.

One of the primary virtues of SMI's Fund Upgrading strategy is it helps keep us from getting enamored with the "winners of the last war."

I was reminded of this yesterday while reviewing our monthly "white pages." These are the data sheets we create each month that serve as the basis for our fund recommendations for SMI Upgraders.

In my review, two funds that performed exceptionally well during the past two "market seasons," respectively, caught my eye. One (a large-company value fund) was a leader during the 2007-2009 bear market; the other (a large-company growth fund) was an outperformer in the years before that. The reason they caught my eye is that each one is currently ranked dead last in its particular category.

Are these bad funds? Absolutely not. On the contrary, these are great funds. I say that because I believe these are two out of a relatively small handful of funds that an investor actually could buy and hold through multiple market cycles and do pretty well over time.

Despite that, we find them terribly out of synch with the market during this stretch, to the point where it is probably quite difficult for many investors in these funds to stay the course and continue to hold them. If you can't hold on through the worst periods for a particular fund or strategy, that's a recipe for trouble, because you're likely going to bail at the worst possible time - right before that strategy/fund starts to make up for that under-performance with a stretch of great returns.

To be sure, Upgrading occasionally gets out of synch with the market, typically at market turning points. But it's unusual for Upgrading to stay out of synch for an extended period of time. That would require the market switching back and forth between bullish and bearish conditions multiple times in a relatively short span of time. Possible, but rare.

Most of the time, Upgrading moves with the market's trend, grabbing an extra percentage point of performance here and an extra point there, in good markets and bad. While we occasionally wish Upgrading would have done better over some recent stretch, we rarely ever have to wonder if Upgrading has completely lost its way or stopped working as a result of it performing poorly relative to the broader market.

Another advantage of Upgrading is that we are able to own great funds (such as the two referenced above) when those funds are in their sweet spot. That's largely what helps Upgrading outpace the market over time. When these funds go into their slumps, Upgrading forces us to sell these old favorites (often kicking and screaming) and moves us to new recommendations that are performing more in synch with the market (and hopefully leading it) during that new market season.

This consistent buying/selling discipline is why Upgrading has beaten the market in 10 out of the past 11 years.

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Mark Biller is Sound Mind Investing's Executive Editor. Learn more about Christian investing and finances at the Sound Mind Investing website.