Recently, a close family member expressed jubilation with regard to Dow 13000. (A feeling of contentment sure beats a feeling of regret!)
Nevertheless, it’s important for ETF Investors to look at "history in the making" as an opportunity to learn; that is, Dow 13000 does not historically reflect the true potential of investing for compounded growth in stocks.
For example, the 10-year annualized return for the Dow Jones Index, including dividends, is only 6.79%. Meanwhile, the 10-year annualized return for stocks historically clocks in at 9.5% since the 19th century. In other words, we’d be on track if the Dow were closing in on 18000, not 13000.
That said, one should understand that one of the many benefits afforded the ETF investor is the ability to trade a diversfied ETF basket like an individual stock. This means an ETF investor can use a trailing stop-loss to protect against the possibility of ever experiencing a loss beyond his/her risk tolerance. (Not only is the protection valuable, but greater compounded growth than 6.79% is achieved when one avoids the destructive nature of bear markets.)
For example, let’s say that you are uncomfortable with losing more than $10,000 on a $100,000 investment in the Diamond Dow Jones Industrials Index (DIA). Then you might be inclined to use a 10% trailing stop order (e.g., stop, stop limit, etc.) so that the price of DIA never falls more than 10% from the highest point you reach from the date of your purchase.
How might this simple approach have helped an investor in the 10-year period April 26, 1997 to April 25, 2007? It would have kept the index investor out of harm’s way in the global credit crisis of July/August 1998. And it would have helped the index investor avoid the bulk of the 2000-2002 bear market declines. When you avoid extreme losses, your principal doesn’t have to spend years recovering.
Buy-n-holders argue that any attempt to "time" the market is asinine. Yet by simply side-stepping the the Diamond Dow Jones Industrials Index (DIA) 4-5 times in a decade, the savvy ETF investor retains more of his/her principal for greater dollar growth, greater compounding returns and less emotional hangups associated with "gretting creamed."
Stop-losses won’t always work out. For example, one might have sold on August 26, 1998 at roughly 83.05 when the global credit crisis was in full swing. Using a trailing stop-loss in reverse, he/she might of repurchased back in at 81.25 on October 16, 1998. Is this a victory?
Since one is repurchasing near the same price he/she sold, it would not appear to be a winning propsect. Still, avoiding the bulk of the fear and the bulk of a 3-month 20% decline in blue-chip stocks, I would argue that using a stop-loss was well worth the peace of mind.
Stop-losses will sometimes trigger a false alarm. On February 11, 2000, the Diamond Dow Jones Industrials Index (DIA) fell 10% from its high point such that one would sell at a price of 105.75. Yet an investor who is exclusively using DIA may have repurchased on March 21 at 107.52. Once again, this roundtrip served only as an insurance policy during a volatile period. (Sometimes, even that is enough!)
Yet the critical points to recognize is that, while no approach is foolproof, stopping an investment before it becomes "big trouble" can be very rewarding. What’s more, leaving one investment gives the ETF investor hundreds of indexing alternatives. (In other words, the 30 stocks in the Dow collectively hitting the 13000 mark is hardly representative of the global possibilities that exist with "new cash on hand.")