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If you invest in mutual funds, know when to hold or fold them


Q: Some time ago, you described your sell and buy disciplines for mutual funds. Now that the market is so high, I'd like to use this system to safeguard my profits. Would you run through the rules again?

A: Gladly! "High" is a relative term that may not appear high at all when viewed in retrospect. When the Dow Jones Industrial Average hit 4400 some five months ago, everybody gasped: This has to be the top. But at 4700, 4400 doesn't seem that high after all.

My buy and sell strategies do not involve forecasting and eliminate the need to guess how high is high. They simply impose a discipline for reacting to what the market is doing.

When you buy a no-load mutual fund, resolve to sell if the share price declines by a specific percentage from its highest point since purchase. I call this the safety net or trigger. A good rule of thumb for determining those triggers is:

* 2 percent for fixed-income funds such as bond funds, tax-exempt municipal funds, government securities or Ginnie Mae funds.

* 3 percent for balanced funds.

* 5 percent for index funds or well-diversified large company domestic and international stock funds.

* 10 percent for specialty funds, such as emerging market funds, sector funds, special-situation funds, aggressive growth funds or small capitalization funds.

As the mutual fund appreciates, the safety net, or trigger, also goes up with it. The trigger is never lowered except when a capital distribution is made. Since capital distribution reduces the price of a share without affecting its real value (as

in a stock split), in this one instance, the trigger should be reduced by the amount of the distribution.

With this strategy, selling is half the battle -- buying back is the other half. Without the second half -- jumping back into the game -- an investor might be better off sticking to the old buy-and-hold-for-the-long-term philosophy.

I recommend buying back when the mutual fund rebounds from the lowest price since selling -- by a percentage equal to half the trigger amount. For example, buy back a bond fund when it goes up by 1 percent from its lowest price, 1.5 percent for balanced funds, 2.5 percent for stock funds and 5 percent for specialty funds.

This safety net also works for loaded funds -- as long as you stay within the same family of funds since transactions within a family do not incur additional fees.

At first glance, these trigger points seem tight and could lead one to believe that using them would cause many transactions. In reality, these triggers have only resulted in transactions four or five times over the past 15 years. I wouldn't call that a high turnover.

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