2

This hasn't been well thought through, but would the following strategy -- over time -- minimize risk in the market and work towards guaranteeing a higher rate of return?

Let's assume a principal investment of $10,000 USD to keep things simple.

  1. Invest in an average risk / high gain mutual fund and hold it until it has gained some minimum percent. Let's say 10% for now.
  2. Sell all shares of that mutual fund.
  3. Invest the gains in a relatively low-interest but guaranteed bond fund.
  4. Reinvest the principal amount in an average risk / high gain mutual fund. Repeat.

I suppose the idea here is to protect oneself from falls in the market but only ever "risking" the principal amount.

Please don't flame this strategy if it's "obviously naive". The reasons for not doing so may be interesting.

  • 1
    Every time you sell shares in a mutual fund in a non-retirement account, there can be tax consequences. In your example, you will have taxable capital gains. So, if you have found a mutual fund that has gained 10% and you expect the gains to continue, there is no point selling all the shares and investing your principal of $10K in another mutual fund: keep the principal where it is. If you think that fund has gained all it could and is unlikely to continue the good performance, then of course switching makes sense. – Dilip Sarwate Sep 19 '12 at 22:03
  • 2
    Why are you selling the whole amount only to buy back the amount invested? What you seem to seek is a mix, say 50/50, stocks/bonds. Every year, just sell what's needed to bring the dollar value of both halves back in line. i.e. rebalance. – JoeTaxpayer Sep 19 '12 at 23:25
  • @DilipSarwate We'll assume that this is a retirement account to avoid the capital gains consequences. – Yuck Sep 20 '12 at 0:55
  • @JoeTaxpayer Would you say that I'm finding a very convoluted way of describing re-balancing then? And does that attempt to solve the issue of being too invested in risky funds? – Yuck Sep 20 '12 at 0:56
  • Yes / The rebalancing mitigates the risk a bit. Long story, but it reduces risk by more than it reduces return. – JoeTaxpayer Sep 20 '12 at 1:10
3

Your idea is a good one, but, as usual, the devil is in the details, and implementation might not be as easy as you think. The comments on the question have pointed out your Steps 2 and 4 are not necessarily the best way of doing things, and that perhaps keeping the principal amount invested in the same fund instead of taking it all out and re-investing it in a similar, but different, fund might be better. The other points for you to consider are as follows.

  • How do you identify which of the thousands of conventional mutual funds and ETFs is the average-risk / high-gain mutual fund into which you will place your initial investment? Broadly speaking, most actively managed mutual fund with average risk are likely to give you less-than-average gains over long periods of time. The unfortunate truth, to which many pay only Lipper service, is that X% of actively managed mutual funds in a specific category failed to beat the average gain of all funds in that category, or the corresponding index, e.g. S&P 500 Index for large-stock mutual funds, over the past N years, where X is generally between 70 and 100, and N is 5, 10, 15 etc. Indeed, one of the arguments in favor of investing in a very low-cost index fund is that you are effectively guaranteed the average gain (or loss :-(, don't forget the possibility of loss). This, of course, is also the argument used against investing in index funds. Why invest in boring index funds and settle for average gains (at essentially no risk of not getting the average performance: average performance is close to guaranteed) when you can get much more out of your investments by investing in a fund that is among the (100-X)% funds that had better than average returns? The difficulty is that which funds are X-rated and which non-X-rated (i.e. rated G = good or PG = pretty good), is known only in hindsight whereas what you need is foresight. As everyone will tell you, past performance does not guarantee future results. As someone (John Bogle?) said, when you invest in a mutual fund, you are in the position of a rower in rowboat: you can see where you have been but not where you are going. In summary, implementation of your strategy needs a good crystal ball to look into the future.

  • There is no such things as a guaranteed bond fund. They also have risks though not necessarily the same as in a stock mutual fund.

  • You need to have a Plan B in mind in case your chosen mutual fund takes a longer time than expected to return the 10% gain that you want to use to trigger profit-taking and investment of the gain into a low-risk bond fund, and also maybe a Plan C in case the vagaries of the market cause your chosen mutual fund to have negative return for some time. What is the exit strategy?

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.