After you study this guide, you should be able to plot out an investment plan that is tailor made for your specific situation using low-cost mutual funds and ETFs. This guide includes unique ideas on how to funds, when to buy them and when to sell them. Keep in mind that I am not suggesting you use the rules I present here verbatim.
Instead, learn and understand what I share here, apply your own filters and get to work. I’ll also present some great resources you can use to make sure the investment rules you set up are consistent with your own investment objectives.
Mutual Fund Investing
Once you’ve identified a bucket of money to invest for growth (and potential monthly additions to it) and clarified your risk tolerance, the next question is how best to deploy that money.
For purposes of this discussion, we’ll restrict our discussion to mutual funds, ETFs and index funds. That means we won’t be tackling the issue of picking individual stocks. That may be the topic of future posts but it is far too involved to cover here and it is not appropriate for most beginners anyway.
Mutual Fund Selection
There are many ways to pick funds. I’m going to demonstrate one simple method that you can build on. This is not the specific method I use to manage money but it is based on similar principals.
The method I use is more complicated and beyond the scope of this guide. That’s one reason I won’t be detailing my exact methodology here. Also, since I am a fiduciary, I can’t provide you with specific investment advice until I get to know you personally. That’s another reason why this discussion is generic.
Again, the purpose of sharing this guide with you is to teach basic concepts that you can sharpen and apply. This is a core approach which I feel can be far better than buy and hold or static asset allocation. My experience tells me that the approach we’re going to discuss can potentially protect investors from nasty bear markets and at the same time, help them grow their assets over time. Of course, there is no guarantee that you will achieve these results.
As I said, you should adapt the system I am about to show you to your specific situation and test it thoroughly before investing. As always, speak with a professional objective advisor before investing as investing involves risk.
How Best To Use This Guide
There are two ways to maximize the value of this guide. First, you can create your own investment strategy based on what you learn here. If you do that, I strongly suggest you back test the method you come up with before putting your hard earned dollars at risk. There are many sites that offer this service. Just search for “back test mutual fund investing” and you will find several.
Usually, they charge a monthly subscription fee but once you are done testing, you can cancel your subscription. While back testing is no guarantee of future results, it’s still a heck of a lot better than flying by the seat of your pants.
If you are not the DIY investor type, this guide can still be invaluable to you. Study it carefully and drill any financial advisor you are about to hire (or are already working with). Ask how they use the concepts presented here and if they are not using these techniques to protect your assets, ask why not.
One Final Word Of Caution
Keep in mind that there is no one way to invest that will always be the best way to invest nor shield you from losing money. No investment approach will always beat the market. What I’m about to share is simply designed to keep you invested in the stronger markets and avoid those which are doing poorly. But again, there are no guarantees that such objectives will be achieved.
How Not To Pick Funds
Before we get to the nuts and bolts of one possible mutual fund strategy, I want to tell you how NOT to invest. Some people want to take short-cuts. While I understand that, I also know from my experience that this can be very costly. One such mistake is investing based on your gut. According to my experience, that usually ends up in disaster. You might get a couple of calls right but over a lifetime of investing, it’s usually a loser.
Besides investing based on your feelings, the next most expensive short-cut I know is picking your funds based on long-term average returns. Intuitively, this may seem like the best thing to do but as you’ll see below, it usually isn’t.
Why Average Returns and Star Ratings Are Dangerous
The problem with this is that average performance can hide some extremely good and bad years. In other words, a particular fund might have a good average return but behind that average could be a high risk fund you need to avoid. And if you only consider the average performance, you’ll miss that.
For example, let’s say a fund had the following returns over the last 5 years:
Year 1 6%
Year 2 7%
Year 3 -19%
Year 4 8%
Year 5 11%
Five- Year Average Annual Return is 2.6%
If you calculate the five year average you’ll find that it is 2.6%. That sounds like a sleepy fund. But is it? If you look at the annual returns (year-by-year) you get a much clearer picture; this fund has been OK over several years but it had one very bad year.
Your next step would be to compare the year-by-year returns with the appropriate benchmark like the S&P 500. That will tell you how this fund performed against the market each year. Can you see why this is far more important than the long-term averages? Long-term averages don’t give you much useful information.
In 2001, many technology funds were rated 5 star funds. Those stars were awarded based on 3 and 5 year performance. And to be fair, these funds had outstanding returns in those prior years. But in 2000 and 2001 they were dying.
And if you bought those funds based on star ratings or long-term average returns alone, you suffered tremendous losses in the following few years as you can see from the chart above.
By 2001, technology funds were already in a nose-dive as I said. That free-fall continued until March of 2003. All you had to do to see that was to look at the recent performance. Obviously, people who ignored that year-by-year performance did so to their own detriment. And if you invest based on stars and long-term averages, you could easily run into a similar problem.
My suggestion is to forget long-term average performance when you buy funds. Instead make sure your investments are doing well right now. What follows is a step-by-step guide on how you might do that:
1. Your Objective
Remember, your goal is to grow your money over the long-term. Short-term results aren’t important, long-term results are. That doesn’t mean you can buy a few funds and just ignore them for years and years. Indeed, if you are reading this post, it’s because you want an alternative to buy and hold because of its inherent limitations.
But no matter what your investment approach is, there will be periods when you will be disappointed. That happens because no one system is perfect. We have to continually remind ourselves of that if we want to stay on track and counter our natural inclinations to react during fearful times.
2. Your Account
I suggest you open your account at a brokerage firm like TD Ameritrade or Fidelity.
Many people like to open accounts at mutual fund companies instead. I understand that because it can be convenient and cheap. As long as you buy a fund that company offers, it won’t cost you anything.
There is nothing wrong with saving a few pesos my friend. But this could be a case where it costs you $10 to save a nickel. Here’s why. If you open your account at a fund company, you can only buy those funds that this fund company offers. That’s a big limitation and if you go this route you forgo other great options.
Think of it this way. Would you go to a pharmacy that only offered medications offered by one company? Of course not. You want to have the widest possible access to the best medications possible.
The same principal applies to investing. If you open your account at a brokerage firm, you’ll have far more investment choices. While many of them will be free of transaction charges, there will be some funds that charge a small fee when you buy or sell them. So what?
Do you really want to be severely restricted in order to save a few bucks? Or, if you decide you do want to have other choices, are you willing to open up 15 different accounts at different fund families all over town just to save a few dollars? It’s just not worth it.
Let’s put this in dollars and cents. Assume you have a $50,000 to invest. If you open an account at a mutual fund company, you won’t pay any fees as long as you buy funds on their platform. Of course, you’ll be limited to only those funds that particular fund family offers.
But let’s say you open an account with a brokerage firm instead. As I said earlier, in most cases, you can find plenty of no-transaction fee funds at most brokerage firms.
But for our purpose, let’s say you will incur 5 transaction fees per year at $15 per trade. That’s a total of $75 for year. If you can find funds at the brokerage firm that perform just 1% better, that would make you an extra $500 which is far more than what you paid for those trades. Do you see my point?
Bottom line – don’t restrict yourself to the mutual funds that are only offered by one mutual fund family. You deserve to have the most choices possible and the best alternatives available. Enough said.
Let’s move on. Assume you’ve opened your account and you are ready to define your investment universe.
Before we talk about which funds to buy, we have to determine which funds we’ll even consider buying. There are several thousand funds and ETFs to choose from and if we consider all of them, we could get pretty bogged down.
So we have to make things a bit more manageable and slim down the list of candidates. For purposes of this exercise, we’ll restrict our universe to index ETFs. We can certainly add funds to our universe in an effort to improve performance but for purposes of illustration, we’ll keep it simple.
In order to have our universe of funds broad enough, we’re going to look for ETFs that track the following indexes:
- Large Capital
- Mid Cap
- Small Cap
- Real Estate
You can of course expand this universe and drill down to finer gradations of each segment as I said. You can also add in other funds you find using your broker’s fund selection filters.
Let’s get back to our example. If you do a little scratching around on the internet you can find ETFs that track these indexes:
I have purposely not published the symbols for these funds. You can easily find appropriate substitutes and I want to make sure that everyone understands that I am not making investment recommendations.
So, these are the indexes we’ll use in our universe. Again, you can use any ETF or fund to represent these indexes and you can add more indexes and funds. Personally, I like to have at least 200 funds in my universe. Again, I’m illustrating one simple approach with only a handful of funds so you get the concept and then expand on it on later.
For purposes of this illustration, we’re going to select funds based on recent performance and focus our investments in the strongest areas possible.
That said, our next step is to determine which of these funds performed best over the last month, 3 months, 6 months and year. Let’s do this scientifically and methodically. Here’s how:
1. Go to Yahoo Finance
2. Input the symbol you want to get numbers for. You’ll get a screen that looks like this:
3. Select “Historical Data”
4. Select “Time Period” and input the last 1 year.
5. For “Frequency” select monthly prices.
6. Next, select “Apply” and “Download”. You’ll get a chart that looks like this:
I put the red arrows to point out that the only numbers you are interested in at this point is the date and closing price.
7. Next calculate the return for the month, quarter, last 6 months and year and tabulate the results for each ETF.
For example, on 11/1/16, the closing price for this particular ETF was $22.56 per share. On 10/3/16, the closing price was $23.40. So, for the month of October, the fund lost $.84 per share ($23.40 – $22.56). If you take $.84 and divide it by $23.40 (the starting price for October) you can see that the fund lost 4% that month.
Just go through this process with each ETF for each period and create a spreadsheet with the results. When you do, you should end up with a chart that will look something like this:
Of course your results will vary depending on which indexes you follow and the time periods over which you execute this analysis.
5. Where to Invest
Now that you have defined your universe and calculated the performance numbers over the various time periods, it’s time to rank your funds.
This is where your own personal preferences come to play. Your rules might call for avoiding any ETF if it shows a negative return for that last 30,60 and/or 90 days.
Or, you might simply add up the totals and invest in the top 3 or 4 choices. Another option is to provide a stronger weighting to certain periods to emphasize their importance. For example, you might take the 3 and 6 month numbers and double them, add up the totals and then pick the top 3 or 4 with the greatest total figures. If you do that, it gives the 3 and 6 month periods more weight in the ultimate decision.
You might also invest 45% of your money in the fund with the highest total, 35% in the fund with the second highest total, and 20% of your money in the fund with the next highest total number. It all depends on your preferences.
Again, you need to establish your rules after you carefully analyze lots of data, testing your results and then sticking with those rules.
For our purposes, we’re going to just give an equal weighting to each time period and sum up the returns for each period:
So, if you only invest in those funds with positive results, you would invest 1/3 of your money in the three funds highlighted above. During this particular period, domestic stocks did poorly compared to commodities, real estate and international stocks.
Markets change constantly and the system described above seeks to track those shifts. In fact, that’s what makes this method so important. I suggest you re-run the numbers each month or quarter and rebalance accordingly. That means you would potentially sell one or more funds and buy new funds or shift assets as each fund’s relative position changes. This potentially keeps your assets invested in funds that are performing relatively well.
What About Bond Funds?
If you decide that owning at least some bond funds works for you, the next question is how to pick those funds?
There is no problem using an approach similar to the one above. Just identify ETFs that are proxies for various bond markets, short-term, mid-term, long-term, government, foreign government, corporate, high-yield and international and find the strongest funds within each category.
Should you always be invested?
Sometimes the overall market is weak. When that is the case, it might make more sense to refrain from investing completely and keep your powder dry.
If you want to do that, one method some investors use is to compare each fund to its 200 day moving average. If the current price is above that line, it might be OK to invest. But if the fund is below that line, you might not buy it even if it qualifies because of its relative total score.
How To Apply A Market Filter To Your Strategy
One way to use this market filter is to use a free charting service to plot the current price vs the 200 day moving average (or any other average you decide to use). One site I love for these jobs is BigCharts.com. Let’s look there to see how this works.
First I go to the site and I input the symbol I am checking – making sure to select “Advanced Chart”.
Once the advanced chart comes up, I select “Indicators” and choose SMA (simple moving average) and type in 200 (you may not see all the digits, but they are there).
Once you select “Draw Chart” you’ll get something that looks like this:
The black line shows the fund’s daily performance and the smooth gold line shows the 200 day moving average. I drew the red arrows to point out how you might use this graph.
Basically, when the black line drops below the golden smooth line, the ETF has fallen below its 200 day moving average. If your rules include this filter, you may want to sell. Likewise, once the fund rises above the average, you may want to invest.
Can A Market Filter Improve Performance?
Below, you’ll see several graphs that show a hypothetical system using a market filter similar to the one discussed above but with some slight tweaks.
The red line shows the yearly performance of the S&P 500 buy and hold. The blue line shows the performance the S&P 500 but only holding that index when the market is above the average used in this model. The green line shows the performance of an S&P 500 leveraged fund only held when the current price is above the average. You can see that this system does not provide an annual return that is always positive or that always beats the market. But the results are very interesting, right?
Let’s look at this a different way:
The graph above shows 10 year rolling performance of the system described above (blue line) vs buy and hold (red line). In most of the 10 year rolling periods the market filter added a great deal of value if you stuck with your system for the entire ten years. But during long bull markets, buy and hold was marginally better.
This makes sense as a market filter sometimes gets you out of the market when you should stay invested. Still, given the added value and protection this particular system delivered hypothetically, it was worth it to pay the “insurance” of giving up a little return during extended bull markets in exchange for having a system to potentially protect you from bear markets. And because going forward, one never knows when the next bear market is going to hit, and how hard the hit is going to be, that potential protection could be very valuable.
Here’s the same graph showing hypothetical results using the leveraged fund:
I am presenting this to you to show you the potential benefits on utilizing market filters and why you might consider doing it. I am not advocating you implement this specific system.
Backtested performance is not an indicator of future actual results. There are limitations inherent in hypothetical results particularly that the performance results do not represent the results of actual trading using client assets, but were achieved by means of retroactive application of a backtested model that was designed with the benefit of hindsight. The results reflect performance of a strategy not historically offered to investors and do NOT represent returns that any investor actually attained.
Backtested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses. Backtested performance is developed with the benefit of hindsight and has inherent limitations.
Specifically, backtested results do not reflect actual trading, or the effect of material economic and market factors on the decision making process, or the skill of the adviser. Since trades have not actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity, and may not reflect the impact that certain economic or market factors may have had on the decision-making process. Further, backtesting allows the security selection methodology to be adjusted until past returns are maximized. Actual performance may differ significantly from backtested performance.
This is not a fool-proof system. There will be times where you sell and then have to go right back in. That can and will happen. But the upside is that you may be able to sidestep a terrible bear market, protect your capital and sleep better at night at the same time. Also, keep in mind that the 200 day moving average is not the only or always the best proxy for the market. I use a different marker.
The Trouble With This Strategy – You
I don’t mean to be unkind, but the hardest thing about using a program like this is your natural inclination to over-ride the system with your feelings. Investing is very emotional for many people and therefore hard to do well. You have to contend with daily swings in the value of your hard-earned nest egg. That can get anyone uptight. I understand that. And that’s why the system I presented is structured to minimize your emotions as much as possible.
The investment program I’ve detailed above focuses investments in those funds that have performed well recently. In my opinion, that’s far better than looking at long-term averages as I said. But it’s no guarantee that your funds will continue to outperform. This method also “takes the market’s temperature” and gives you a signal when to exit.
There is no guarantee that these safeguards will always work. In fact, I can promise you that they won’t. Over the course of your investing career, you will get false signals. That goes with the territory friend. Sorry. It’s good…but not perfect.
My fear is that when some terrible headline hits the news and/or your funds significantly underperform or the market hits a rough patch you’ll throw your system out the window and run for cover. That is a natural thing to want to do. But don’t cave in. If you do, you’ll likely pay a high price over time.
There are two ways to inoculate yourself against this problem. First, if you are doing this yourself, back test your system over and over again. Only use a system that has a worst-case situation you can live with. At the same time, it’s important to understand that this is still no guarantee that future downdrafts won’t be worse.
The second way to address the problem of investing emotionally is to use a qualified advisor who agrees that it makes sense to invest in stronger funds, to avoid weak funds and avoid weak markets as well.
Investing Summary and Checklist.
There you have it. A simple investment system you can use or build on with a goal of focusing assets in stronger markets and avoiding weaker areas.
Let’s recap your action steps to put this to work for you:
- Remind yourself that this is about long-term investing and that no system is perfect. Stick with it.
- Set up your account at a good brokerage firm.
- Define your universe.
- Tabulate returns for the prior 1, 3, 6 and 12 months or whatever periods make sense for you.
- Determine your other investment rules such as weightings, what to do with negative returns, how many funds to buy and whether or not you are going to use a market filter or not. You should only make these decisions based on results you see when back testing. And you must remind yourself that the backtesting is not a guarantee of future performance.
- Rebalance monthly or quarterly.
As I said, the system I use for clients is more involved. If you want information about that, contact me here. But the bottom line is, the investment method I described above can potentially be far better than buy and hold because it provides objective guidance free of emotional interference.