Mutual fund investors must be prepared to switch from one fund to another as economic conditions change. Today, the most common type of switching is likely to be from a stock mutual fund to a money market fund and vice versa.
The biggest question is, when should a switch be made? Of course, there is no precise formula, but the following approach may provide some idea of when to complete the transaction.
Over a period of about 30 years, the average annual return on all mutual funds, allowing for reinvestment of dividends and capital gains, would be about 10%. This suggests that the mutual fund investor, over a span of time, can expect a minimum return of at least 10%. Taking taxes and inflation into consideration, you should set a somewhat higher yield objective than 10%. Assuming a 12% level is determined, whenever the yield on money market funds exceeds 12%, a switch from a stock fund to a money market fund may be indicated. When the yield on a money market fund drops below 12%, then a switch to a stock fund might be considered. The switch need not be undertaken all at once. A gradual easing into one or the other is usually preferable.
Another factor to consider is sales fees or loads. Some fund “families” may charge fees to switch, but many do not. It is generally advisable to switch funds within a family of funds because loads may be eliminated.
This switching technique is based on the assumption that corporate earnings and stock prices will decline when interest rates are high and increase when interest rates are low. When interest rates begin to fall, a fund investing in intermediate term tax-exempt securities or bonds might be an ideal alternative for investors whose combined federal, state, and local taxes are 40% or more. The maturities of these tax-exempt investments could lock in higher interest rates for the period of average maturity, which may be a year or more. When interest rates fall, investors also enjoy an increase in the value of their principal investment because other investors will pay a premium for an investment yielding a higher return.
[Note: Investors should always bear in mind that investment returns and principal values of mutual funds will fluctuate due to market conditions so that shares, when redeemed, may be worth more or less than their original cost.]
In addition to fund switching, individual mutual funds provide more diversification than the average investor would be able to achieve on his or her own. So it is prudent for mutual fund investors to divide investments between different mutual funds and thus protect against possible poor performance by any one particular fund. Diversification and switching between funds may offer you the potential to help maximize your long-term investment growth.