I bought shares of a growth fund back when it traded at $18. Now it's worth half that. Should I hold, or fold?
QUESTION: I purchased the Vanguard Growth Equity fund (VGEQX) in 2000, when it was highflying. The price I paid was about $18.00 per share. Now it's down to about $9. Is it wise to keep it as a long-term holding, or should I depart with my tail between my legs?
ANSWER: Many investors hate to admit they've made a mistake. As a result, they often hold onto losing investments in the hopes that someday they'll turn around. But assuming you hold Vanguard Growth Equity in a taxable account, continuing to hold it might be the biggest mistake of all. Not because this is a bad fund -- it's not, as we'll explain later -- but because selling a fund at a loss can be a powerful tax maneuver. You can reap a nice tax break for your troubles -- and later buy back the fund if you so choose.
First, a little background on your investment. It was five years ago this week that the Vanguard Growth Equity fund peaked at $20.88 a share. You had the misfortune of buying at a bad time: A year later, it had lost half its value, and by July 2002 it had bottomed at $6.14. And while during the past year and a half it has crawled back to about $9 a share, it will still be quite a while until investors who bought at the peak recoup their losses.
Consider this: Assuming the fund earns an average of 8% a year, it would take nine years for your current investment to double -- and thus get you back to where you started in 2000, says Don Cassidy, senior research analyst at mutual fund tracker Lipper. This is based on the so-called "rule of 72," which calculates the time needed for an investment to double by dividing 72 by the expected growth rate. If a fund earns 10% annually, for example, rule 72 says it would take a little over 7.2 years for it to double; 12% annual growth means six years to double, and so forth.
Given the numbers, the best you can do right now -- again, assuming you hold the fund in a taxable account -- is to sell the shares and claim a capital loss on your 2005 tax return, says Cassidy. This way, you'll be able to offset any capital gains dollar for dollar. Then, if you've exhausted your gains and still have capital losses left, you can use an additional $3,000 of ordinary income as an income tax deduction, explains Martin Nissenbaum, national director of personal income tax planning for Ernst & Young. And if you still have losses to offset after that, they can be carried forward to next year.
Confused? Here's an example. Say your initial investment was $10,000. Right now, it should be worth about $5,000. (For simplicity, we aren't factoring in any reinvested dividends or capital gains.) This means you have a $5,000 capital loss. Now, let's assume you sold some stocks this year and had a long-term capital gain of $1,000. You can use your $5,000 loss to offset that $1,000 gain (so you don't owe tax on it, which means a potential $150 tax savings). Now you're left with $4,000. You can deduct $3,000 from this year's taxable income; next year, you can use the $1,000 that's left. If you're in the 30% tax bracket (state and federal combined), that's an additional tax savings of $900. Granted, it doesn't make up for the $5,000 loss, but it sure helps alleviate the pain.
What you do with the money next depends on your investment style and overall asset allocation. If you believe the Vanguard Growth Equity fund still fits into your portfolio today, you can wait 31 days in order to avoid the wash sale trap, and then buy new shares. Alternatively, you can use the cash to invest in any other mutual fund, stock or flat-screen TV if you so desire, immediately after the sale.
If you hold the fund in a tax-advantaged fund like a Roth IRA, however, you've got a tougher decision to make: hold or sell. Let's take a closer look at Vanguard Growth Equity.
As you probably know, this is a large-cap growth fund -- and growth funds as a whole haven't done that well since the recent bear market. "Growth has been out of favor for the past five and a half years," Cassidy says. Moreover, large caps have trailed small caps throughout the entire span.
The Vanguard Growth Equity fund has fared even worse. While the large-cap growth fund category lost an average 8.55% annualized over the past five years, according to Morningstar, this fund lost 13.62% (data is through February 28). But it outperformed its peers over the long term -- 8.51% over the past 10 years, vs. 8.30% for the category.
The reason for the disparity: This fund tends to play a bit harder than some of its peers. While this more aggressive stance has helped it over the long run, it has also led to greater volatility. Its standard deviation, a measure used to gauge a fund's volatility, is 23 over the past 10 years, compared with 19 for the large-cap growth category, according to Jeffrey Ptak, a senior fund analyst at Morningstar. "That's a pretty significant difference, and an investor is certainly going to notice that over shorter periods of time," he says. "Especially when the particular strategy that management uses is out of style -- and obviously, that happened with large-cap growth funds during the bear market."
That's not to say the Vanguard Growth Equity fund is a bad investment. On the contrary, it's one of Morningstar's picks in the large growth category, according to Ptak. "We usually reserve that distinction for funds that we have the most conviction in," he says. The fund's most attractive features are its good management, consistent investment strategy and low expenses, says Ptak. But at the same time, he recognizes that its aggressive strategy isn't for the faint of heart. "I would urge investors to look very closely at how volatile it's been, whether that fits with their risk tolerance and time horizon," he says.