by Archie M. Richards, Jr., CFP^®
May 24, 2004

If you own a broad diversity of exchange-traded funds, don't use stop losses.

First, to define the terms: Stop losses are orders that trigger a sale of an investment if the price drops to a certain level.

Exchange-traded funds (ETFs) resemble index mutual funds. Each ETF holds stocks of a certain type, such as those of Japan, the stocks of a particular industry, or those included in the S&P 500 Index. There are over 200 ETFs. But unlike mutual funds, they can be bought and sold throughout the trading day.

In my book, "All About Exchange-Traded Funds," I recommend a variety of ETFs, representing the stocks of various foreign regions, various kinds of U.S. stocks, real estate investment trusts (REITs), and bonds.

Leah writes that she plans to follow my recommendations. She constructed a hypothetical portfolio of the suggestions for the period beginning January 2, 2003. Until May 1, 2004, the portfolio was ahead 26 percent.

But in the next 10 days, the gains were cut significantly. Leah doesn't want her money to be "affected negatively." She wonders why my book didn't suggest protecting profits with the use of stop losses.

Stop losses are sometimes needed with individual securities, Leah, to keep losses modest. But with a variety of exchange-traded funds, they don't work. ETFs represent entire markets and don't fall to zero. There's a pendulum effect in human affairs. Investment sectors that are down eventually rise again.

For 15 years until 1994, for example, foreign stocks outperformed U.S. stocks. In especially good years, a person was wise to sell some of the foreign stocks, adding the proceeds to U.S. stocks.

For 8 years until 2002, foreign stocks did worse than U.S. stocks. In especially good years, a person should have sold some of the U.S. stocks and added to the foreign.

Selling portions of sectors that are especially strong and buying those that are weak is called rebalancing. It's an automatic system for selling high and buying low. It's the right approach.

If you use a stop loss, where do you put the money? Reinvest it in groups that haven't fallen as much? But if those groups then fall, additional stop losses would be executed. All along, you're reducing your diversification.

Worse yet, when sales are made in a falling market, most investors hold cash until the news improves. But by then, the prices are usually higher than when the sales were executed. Stop losses are automatic ways to sell low and buy high. It's the approach for losers.

Just stick with a variety of investment sectors. In 2002, bonds and REITs rose while stocks fell. Good sectors negated some of the bad. Diversification paid off.

Sometimes, no matter what you do, everything goes against you for a while. Lately, for example, stocks, REITs, and bonds have all gone down. If you think your long-term investments will never be "affected negatively," you're living in a dream world.

You're investing money you intend to spend a lot later. If you try to protect your profits by selling when prices are down, you'll have fewer profits to spend.

With the Dow now at 9967, I suspect the market has already hit bottom. On Friday, May 7, more than 20 percent of the stocks listed on the New York Stock Exchange reached 52-week lows. Such an event has occurred approximately 18 times in the last 20 years. In every case, the market was higher three months later. The average gain 90 days later was 16.8 percent. The average gain 120 days later was 19.2 percent.

At the beginning of 2004, I predicted the Dow would close the year at 12,300. I hold to that prediction. If it proves correct, prices will have gained about 23 percent from current levels.

The stock market is always a surprise. When everyone's pessimistic, the surprises are usually favorable. Just hang in there. If necessary, quit watching television business news and quit checking stock prices. Do whatever you must to ride through the difficulties. They won't last.