Some mutual funds need an exit strategy

Most financial advice says that you should buy a mutual fund and hold it until the mountains fall into the sea, the stars fall from the sky, and your insurance company resolves a dispute in your favor.

But some funds were just born to be sold: In fact, a buy-and-hold approach makes little sense for many funds. You should have your exit strategy planned when you first plunk down your money.

First, let’s make a big distinction. Diversified mutual funds, such as broad-based U.S. stock funds, really are long-term, buy-and-hold investment, even though they have been stomped lately.

But assuming that a broadly diversified stock portfolio will gain in value over 10 or 20 years isn’t exactly wacky, pie-in-the-sky thinking. Good returns aren’t guaranteed, because if they were, you’d get the same returns from stocks as you would from any ultrasafe investment, such as Treasury bills. Nevertheless, the odds are generally in your favor if you bet that stocks will outperform bonds and money market funds over the long term.

Some funds, however, simply aren’t long-term investments. Sector funds, which specialize in small sections of the market, aren’t long-term investments. Neither are funds that specialize in a small region of the globe. Nor are emerging-markets funds. They were made to be traded.

The longer you hold a specialized fund, the more likely you are to have a catastrophic loss of 50 percent or more. And in most cases, all the hot returns in previous years aren’t enough to compensate for the dreadful losses.

Consider precious metals funds, which invest primarily in gold-mining stocks. From 2005 through 2007, the average precious metals fund would have turned $10,000 into $21,207.

This year, however, the funds have plunged along with gold prices. The average precious metals fund is down 59.2 percent this year, turning your $21,207 to $8,652 – a 13 percent loss on your original $10,000 investment.

Emerging markets also tend to fall apart with distressing frequency. ING Russia fund, for example, gained 30.7 percent last year, but has plunged 74 percent this year.

Now, if you like to speculate – and there’s nothing wrong with that – then feel free to invest in highly specialized funds. But make some rules for selling before you buy.

Most selling guidelines won’t protect you from all losses, but they will help protect you from catastrophic plunges. For example, if you invest $10,000 in ING Russia and lose $1,000, you’ll feel foolish, but your account will live to fight another day. A 10 percent loss requires an 11 percent gain to get back even.

Lose 50 percent, however, and you’ll need 100 percent to get whole again. So how do you decide when to sell?

•Target prices. Decide that a 10 percent loss is all you can stomach. Write down your purchase price, subtract 10 percent, and sell if the fund hits that level.

Be careful this time of year, however, because this is when funds distribute capital gains. The gain is subtracted from the fund’s share price. So a fund that sells for $10 and distributes $1 per share in gains will fall immediately to $9 a share.

•Stop-losses. If you’re investing in an exchange-traded fund, consider using a stop-loss order, which is a standing order to sell if a fund reaches a certain price. Although you’re not guaranteed to get the price you set, a stop-loss order will prevent you from taking horrific losses.

•Moving averages. Sell when your fund’s share price falls below its average price for the past 200 days. (Most investment sites, such as investor.com or finance.yahoo.com, will calculate this for you). The drawback: A fund’s share price can bounce around the 200-day average for some time.

On the other hand, you would have sold ING Russia in July, when the fund’s share price was about $70. It closed Wednesday at $12.33.

No one likes to sell, particularly when it means that your brilliant speculative play was, well, dumb. But it’s better to sell early than wait an eternity to get back even.