Many nervous investors left the equity markets at some point over the last year, either as an investment strategy or out of pure panic and fear. These feelings were magnified for baby boomers and others in the home stretch toward retirement.
Others investors were like me. We did not sell during the market decline (except perhaps financials and other sure losers) but we did not add to our equity positions either.
Now the market is in a small rally and there are glimmers of positive news about the economy. We remain nervous. So how does the conservative retirement investor get back in the market without breaking out in a cold sweat? I have a one strategy to propose. It involves three basic steps.
Step 1: Buy Exchange Traded Funds
Finally, and most important to my proposed strategy for re-entering the market, ETF’s are bought and sold like stocks. This means that you can get in and out of an ETF in a hurry during the trading day. It also means that you can use risk and loss-control strategies for ETF’s that you cannot use for mutual funds.
Some experts predict that the number of mutual funds will decrease over the coming years and be replaced by ETF’s. Even today, it is very easy to construct a nice retirement portfolio using only index ETF’s, including lazy man or couch potato porfolios.
Step 2: Use Stop Loss Orders
Now that we have our ETF portfolio in place, we want to limit our risk if the market crashes again. It used to be that a proper asset allocation would do this but recent events now cast doubt on that strategy working well by itself. So a second tool is the stop loss order. Because ETF’s trade like stocks, this is a viable tool. Stop loss strategies are not as easy to implement for mutual funds.
The concept of a stop loss order (also known as a “stop order” or “stop market order”) is quite simple. You instruct your broker to automatically sell your position (in this case your ETF) if the market price for the ETF falls below a dollar value that you specify.
Let’s assume that you buy 100 shares of ABC brand ETF at $50/share. You decide that you cannot tolerate greater than a 10% loss on your investment. Therefore, you instruct your brokerage to automatically sell if the ABC ETF share price drops below $45.
Stop loss orders can be used with most online brokerage accounts as well. The key is that you don’t have to be monitoring the market or making any other decisions to limit your losses.
Step 3: Use Trailing Stop Loss Orders
One of the weaknesses of using a standard stop loss order arises when the market is generally rising. For example, if the share price of our ABC brand ETF slowly increases over time to $60, our stop loss order at $45 would cause us to incur a loss of 25% from its peak. That is less than ideal. One solution to that is to constantly reset our stop loss order as the share price moves. That is awkward and time consuming.
The better solution is to use what is known as a “trailing stop loss order.” With this strategy, you instruct your broker to sell if the market price falls (at any time) more than x%. You get to select the value of “x.”
To see how this works, consider the following example for an ETF purchased at $38 per share with a 10% trailing stop loss order.
Initially, the trailing stop order would be activated at $34.20 per share ($38 x 10% = $3.80; $38 – $3.80 = $34.20).
Now let’s see what happens if the ETF share price keeps moving up with a 10% trailing stop order:
- At $39 per share, the trailing stop is $35.51
- At $40 per share, the trailing stop is $36.00
- At $41 per share, the trailing stop is $36.90
- At $42 per share, the trailing stop is $37.80
As the share price increases, your trailing stop order not only prevents you from suffering a loss greater than you can tolerate, it will lock in some minimum percentage of your profits as well.
Final Thoughts on Re-Entering the Market Using an ETF Portfolio and Stop Loss Orders
Obviously, a key component of this strategy is selecting a stop-loss point that is not triggered by routine daily fluctuations in market price for the ETFs you own. That requires investigating the volatility of the specific ETF’s during daily trading.
Another issue you may confront is with your retirement (tax deferred) accounts, such as an IRA or 401k. You may not be able to use stop loss orders inside those accounts so be sure to check first. I don’t have that problem because my 401k account has a self-directed brokerage option.