ETF Investing: Making A ‘Buy’ Decision

Reader Gy posted an interesting question, which I like to share with everyone since it addresses a problem faced by most investors.

Here’s what Gy had to say:

Thanks for your assistance. In fact, I bought GDX and SLV two weeks ago.

However, in regards to the energy ETF fund and agriculture Fund I am stuck here. From your fund list, currently UCR and DBA have the best M-index 12. My feeling is I am little bit afraid of investing in both of them, and actually I have been waiting for two weeks because I felt both of them were in an overbought region thus I wanted to wait for a pullback.

However, it looks like the more I wait the more hesitation I now have because UCR did have a pullback and it may retreat more. DBA did not pull back and it even entered a much more overbought region. This may be a very common question for use with your models, please let me know how I can solve this problem.

This is a very common question to a common problem we all face—investors and advisors alike. Once you have analyzed a mutual fund/ETF, looked at the momentum figures and consulted the charts to confirm that an uptrend is indeed intact, you have reached the point where the rubber meets the road. In other words, there is nothing left to do than making a decision to buy.

However, before you do, there are two items you need ask yourself to clarify in your own mind how to control and limit the risk of this investment:

1. How much of your portfolio are you going to invest? That factor strictly depends on your own risk tolerance. Since we’re discussing more volatile sector funds, I personally allocate no more than 10% of portfolio value to any one sector. You can use any percentage you are comfortable with.

2. You need to determine your sell stop point, so that you can track it daily. The only way you can gain any piece of mind when investing is by using clearly defined entry and exit points. In regards to the latter that means how much are you willing to lose before admitting that you were wrong about the trend direction before you get out? If your attitude is that you don’t want to lose, then you should not invest because losses are part of the equation, whether you like it or not.

The key issue here is not to avoid losses, because you can’t, it is keeping them small enough so that any one bad/early/wrong decision does not wipe you out, but keep you in the game.

Here’s how I approach it. Once I made my investment in a sector ETF, I track it daily and monitor my trailing sell stop point. If it goes my way, the sell stop point will eventually stop me out at a profit whenever the trend turns.

If it doesn’t go my way, and the markets head south they will eventually trigger my 10% stop loss (using day end closing prices only; not intra day data); I will have lost 10% of my investment. If I allocated, as mentioned above, 10% of my portfolio value, the net effect on my portfolio will be a negative 1%. That was the risk I took when I entered this trade, and I was fully aware of it. To be clear, for volatile sector and country funds, I use a 10% trailing stop loss while for domestic and broadly diversified equity funds, I use 7%.

So my risk is always known and that’s how you should to look at it too. Could you reduce your risk even further by using tighter stops? Sure you could, but I don’t recommend it since the markets need to have some room to “breathe.” If you keep your stops too tight, you will be whipsawed constantly.

I want to go one step further by saying that if this type of risk scenario is something that makes your stomach turn, you should not be investing in the market place. Risk will always be present; the key is to limit it as discussed. Right now, with the markets in a shakeout mode, even trying to get onboard of established long-term trends may feel like riding a bucking bronco. Sooner or later trends will become more firmly established which will make it easier for us ride them until they turn.