Take advantage of decline to shed weakest holdings. (Mutual funds).

WONDERING what to do next with your mutual-fund investments? Now might be a good time to take out the trash.

By "trash" I refer, a bit harshly perhaps, to any fund among your holdings that no longer fits the purpose or the promise you had in mind when you bought it.

After a mighty boom-bust cycle in the stock market, plenty of funds may be candidates for disposal: a fallen dot-corn darling, for example, or maybe a globe-trotting fund specializing in emerging markets that have never quite managed to emerge.

Perhaps you've lately concluded you aren't the adventurer you thought you were when you loaded up on aggressive growth funds during the glory years.

Well, the calendar provides an incentive to consider such matters soon. Sell before Dec. 31, and any loss you realize may knock something off the tab in your 2001 income-tax account. It's a situation where Uncle Sam really does stand ready to share at least a little of your pain.

As in any other financial endeavor, there are rules to observe and missteps to avoid if you want to play this game right.

In the event you bought a bear-market casualty long enough ago that you still show a profit on it, for instance, you might consider making a charitable donation of your shares rather than redeeming them for cash. That way you avoid capital gains taxes and get a deduction for the full market value of the contribution.

Careful giving

But don't donate shares you hold at a loss. "Unless the charity needs the property for its own use, you should not donate property whose value has declined below your cost," says J.K. Lasser's "Your Income Tax," the familiar annual guide whose just-published 2002 edition runs a mind-numbing 800 pages. "You may not claim a deductible loss when you make a gift?."

If, instead, you redeem the fund shares first and then contribute the cash proceeds of the sale, you get a charitable deduction for the amount of the donation, while preserving the loss on your investment as a write-off on your return. Losses can be used to offset any capital gains you have realized, plus as much as $3,000 of other types of income.

Whenever you sell an investment, it helps to have an idea what you're going to do with the money afterward. As long as your investment objectives haven't changed, you may even want to plow it right back into the same security.

Remember, though, that the tax rules forbid you to write off a loss from such a "wash sale" unless the sale and repurchase occur more than 30 days apart. To make your moves closer together, and thus avoid the risk of missing a market move in your favor, you can put the proceeds into a similar but not identical security.

For example, if you bought a Standard & Poor's 500 Index fund around this time last year and have since ridden it down 20 percent or so, you could switch now to a fund based on the broader Wilshire 5000 Total Market Index.

Swaps in no-load funds may cost you little or nothing in transaction expenses. Anywhere else, beware of commissions, redemption fees and any other costs that could negate some or all of the tax savings you're out to achieve.

What about moving from a high-risk fund to a more conservative one? That may make sense if you have determined you were taking unnecessary chances with your money heretofore.

If you turn conservative simply as a reaction to ugly market conditions, you risk a classic timing error. Playing the game aggressively, at market tops and conservatively at market bottoms may well put you in the wrong place all the time.

"Without a crystal ball, staying the course with your current asset mix is likely the best response in this volatile period," says Tim Schlindwein, a Chicago mutual-fund consultant.

Though too much tax maneuvering can mess up any long-term investment plan, the urge to "harvest" a tax loss can serve useful purposes too. If it forces me to overcome inertia and give my holdings a close appraisal every now and then, it might yield benefits well beyond whatever taxes I don't have to pay.

Chet Currier is a columnist with Bloomberg News.

RELATED ARTICLE: Hunt for Fund Bargains Proves Elusive

Mutual funds always frustrate investors who insist on getting a bargain.

Because fund shares sell for net asset value (NAV), they never give you an. opportunity to pick them up cheaply. A traditional open-end fund issues new shares when you buy, and retires your shares when you redeem.

Contrast that with the smaller category of investment companies called closed-end funds, which have a fixed number of shares that trade like stocks. As investors buy and sell these shares among themselves, the going price can fall to a discount below net asset value.

One thought keeps bedeviling me -- the notion that there still ought to be advantages at least once in a while to buying a cheap laggard fund over a popular, successful one.

Suppose I am faced with a choice between a fund noted for its consistent gains over the years, and one whose style was to lag far behind the pack before closing with a rush in the stretch.

Say each fund is currently priced at $10 a share, and I intend to put $1,000 annually into it now and for the next nine years. For simplicity's sake, assume neither fund makes any distributions of capital gains or dividends.

The first fund's net asset value per share rises $1 a year for each of the next l0 years. My annual contributions buy shares at $10 now, $11 next year, $12 the year after, until the price reaches $19, at which point I make my 10th purchase. Then the fund's NAV moves on to $20 in the 10th year.

My $10,000 in purchases works out to an average price of $14.50 a share, which. gets me a total of 68965 shares. At a final price of $20 a share, my investment will have grown to $13,793.10.

The second funds performance is so sluggish that its NAV averages just $10 all the time I am buying. Only in the final year does the manager get his act together, Producing a 50 percent bounce that lifts the NAV to $15.

To judge by standard ways of measuring, the initial fund, at $20, has performed twice as well as more sluggish fund, at $15, over the period of my investment. Yet my 1,000 shares of laggard fund, now at $15,000.00, are worth more than what the consistent fund brought.

When I'm making periodic investments over a long period of time I might redouble my resolve not to jump to too many conclusions based on disappointing performance over six months or a year.