Implementing the trailing sell stop strategy is imperative to your portfolio surviving treacherous times as this century has shown.

Even though it has been discussed before, new readers may bring up old questions, but they are nevertheless important to be reviewed again. Here’s the latest one:

Sorry for a potentially dumb question, but do you know if trailing stops are commonly provided by the big names? I cannot seem to find it with Vanguard, but it seems to be there for Fidelity. Should I do my best with an excel sheet if I do not have the option available at one?

Actually, this is not a dumb question at all. It simply shows that you are seeing the wisdom of using stops and are trying to find a way to apply them with your existing custodians.

As you know, there is no way to place stops for mutual fund holdings. You need to track the highs your funds have made since you have purchased them on a spreadsheet and update the prices daily. That’s what I do.

For ETFs, you can place orders for sell stops with any of the large brokerage houses. However, I do not recommend you do that, because intra-day market activity might stop you out and prices may subsequently rally.

In that respect, I treat mutual funds and ETFs alike. I track the day-ending prices on a spreadsheet and, if a sell stop has been triggered on that basis, only then do I enter the order the next trading day.

For domestic and widely diversified international funds/ETFs, I use 7%; for more volatile sector and country funds/ETFs, I use 10%.

The question in your mind might be when do I exactly pull the trigger? Right at 7%, or at 7.1%, or do I wait until 7.5%? That’s where a little bit of subjectivity comes into play.

Say, a domestic ETF closes off its high by 7.1%. Do I sell the next day? No, I personally like to see a clear piercing of the 7% level. For example, if the markets drop sharply that day and this ETF closes down -8%, I will place my sell order the next day.

If it closes down -7.1% or so, I might wait another day to see if the market rebounds. If it does, I patiently wait. If it does not, and the next day we’re heading towards -8%, I will liquidate. It all depends on your risk tolerance; only you can make that decision.

Reader Ken pointed to an article titled “Tax Traps for IRA investors in Short ETFs.” While it was written the beginning of this year, when the markets tanked, the issue, however, is still important.

Here are some highlights:

With the market down about 9% year-to-date, everyone is looking at making money shorting the market. It’s not easy: the downside potential is unlimited. Stocks sold short can be called away by the brokerage firm while a position is at a loss, thus, realizing the loss.

However, activities inside of these funds can cause the shareholder to file taxes even if they are bought inside an IRA. This occurs when a tax-exempt entity participates in business that is not deemed tax exempt by the Internal Revenue Service as part of the Employee Retirement Income Security Act of 1974 (ERISA).

[Emphasis added]

Over the years, I have talked with many investors and clients who had holdings in these types of short funds, especially BEARX, since it has been around a long time. However, I have never heard anyone bringing up the potential tax liability in an IRA account.

If you are an accountant, or have had tax issues as described above, please add your input as to how frequently this applies or if this will only occur as a random event depending on the fund’s activity.

I am traveling this weekend, but regular posting will resume on Monday.

Target-date funds, which are widely used in 401k plans because many investors assume they have less risk, failed miserably during last year’s market meltdown.

SmartMoney reports that Morningstar now has come out with a new ranking system designed to make it easier to compare these types of funds:

Ever since target-date funds were introduced a few years ago, critics have complained that the funds — a mix of stocks and bonds that are supposed to get more conservative the closer the investor gets to retirement age — are nearly impossible to compare to one another.

Not anymore, says Morningstar, the biggest and most popular mutual fund research and ratings firm. On Wednesday the company announced its first comprehensive rankings of the funds. Vanguard, known primarily for its low-cost index funds had the best group of target-date funds. Oppenheimer was ranked last. Fidelity, the largest manager of target-date assets, offers two series of target-date funds: its no-load Freedom Funds were rated “average” and its advisor-sold Freedom Advisor funds were rated “below average.”

Again, while it is helpful to compare apples with apples, it does not mean that these types of investment can be purchased indiscriminately.

I wrote about these funds, which used to be called Lifestyle funds, during the last bear market in 2002 in an article called “Do Lifestyle Funds Provide Greater Security?” Their miserable bear market performance then was repeated in 2008 to the same degree.

Don’t let ranking schemes give you a false sense of security. These types of funds will work in bull markets but will harm your portfolio when the bear shows up for his curtain call. As always, if you invest in anything, be sure to use my recommended exit strategy to protect your portfolio should disaster strike again.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

The bulls remained the upper hand during the first week of September, and all major indexes gained.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +7.88% keeping the current buy signal intact. The effective date was June 3, 2009.



The international index has now broken above its long-term trend line by +16.00%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.



[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Two days ago in “A Hopeless Reader,” I talked about the importance of knowing your risk tolerance. Reader Mel had this to say about it:

I’m worried too, but going from fully to zero to 75% invested in a matter of days? If I don’t know which way the market is going, I try to pick a percentage–50, 30, etc–that I can live with for at least a couple of weeks while waiting to see if there’s a direction forming. That way I’m not pretending to know something I don’t know, and I’m protected either way.

It appears to be a common problem trying to find an entry point to deploy a certain percentage of assets after the markets have rallied, and you have sold out prematurely.

Here’s an easy way to determine your risk tolerance. Say, you have a total portfolio of $100k in cash and want to re-invest in the market. How aggressive should you be? Should you go in 100% this late in the game or use a smaller percentage?

Let’s find out where you are coming from in these 3 scenarios:

1. Imagine that you have invested your entire $100k all at once and, right thereafter, the markets head south and your sell stops are triggered leaving you with a 7% loss, which equals $7,000. How do you feel about that? Are you aggressive enough to accept that situation without being emotionally upset? If not, move on to number 2.

2. Assume that you only invested $66k (2/3 of your portfolio value) and the same circumstance as above occurs. The markets reverse their trend right after your purchase, and you lose 7% again. Since you only had $66k invested, your actual dollar loss would be some $4,600, which represents 4.6% of your total portfolio. Do you find this risk more acceptable? If not, move on to door number 3.

3. Same situation as above, except your initial investment is only $33k (or 1/3 of total value) before the markets head south again. Using the same 7% sell stop, your loss would be $2,300 or 2.3% of your total assets. Is that more in line with your risk tolerance?

If not, you should not be in the markets to begin with. This is a simple but quick and effective way to evaluate your risk profile. Sure, you can get far more complicated, but what it comes down to is how much can you accept to lose while in pursuit of growing your portfolio?

Next time, you are faced with an investment decision, apply these simple rules (and involve your better half if necessary), and you will find that your decision becomes much easier.