Building the Target Market Segment, Starting with Gold

This is the third lesson in our ten-part series on investing from Lee Hevner and our friends at the National Association of Online Investors. The first two lessons are available to JK Lasser members and can be found here.

Review of Lesson 2 (available to Lasser members): In Lesson 2, I showed you how to build the core segment of your portfolio. The core segment consists of the traditional asset classes of cash, stocks, and bonds. You learned how to include each of these assets in your portfolio by using a money market fund for cash and one exchange-traded fund (ETF) for the total U.S. stock market and one ETF for the total U.S. bond market. In the Lesson 2, I directed you to online resources and provided a data collection worksheet for finding the "best" ETFs for this purpose. At the end of Lesson 2, I used as my sample selections AGG for the bond ETF and SPY for the stock ETF. With the core segment in place as the relatively conservative foundation of the portfolio, we are now ready to start building the target market segment, the portion of the portfolio that will "'supercharge" its returns.

Lesson 3: Building the Target Market Segment, Starting with Gold

The purpose of this lesson is to introduce the target market segment of the portfolio we are designing in this course and to begin building it with an investment in gold.

The purpose of the target market segment is to boost the returns of the entire portfolio. Here, we will consider including the following assets as portfolio building blocks: gold, energy, agriculture, commodities, real estate, and emerging markets. These are more volatile investments than we included in the core segment, and in exchange for higher returns we must deal with higher risks. To mitigate this risk, in the target market segment we will need to buy and sell investments as opposed to simply buying and holding them. Lessons 3 through 7 will be devoted to explaining how to invest in each of the above-listed target market asset types.

The Target Market Segment Building Process

To build the target market segment, we will perform the following activities for each of the five asset types listed just above:

• We must first understand the asset type and the factors that can affect its price.
• We will then identify multiple ETF candidates that represent the asset type. We will look for a minimum of three ETF candidates for each.
• For each ETF candidate, we will collect the following data: returns, risk, expenses, and volume. For this purpose, we will use the worksheet shown below.
• We will then compare the data collected on the worksheet and select one ETF to represent the asset type we are considering.
• After selecting an ETF, we will use Web resources to view its price chart to first decide if now is a good time to buy this investment and, if so, to create a trading plan for it.
• In Lesson 8, after studying each of the five target market asset types, we will decide how much money to allocate to each as we design our total portfolio.

The Data Collection Worksheet

The following worksheet will be used to record the ETFs that we decide to analyze and compare for each of the five target market building blocks.

To fill in the worksheet you can use any of a number of Web sites. I will use the site at finance.yahoo.com for illustration purposes. On this site, after entering the symbol of the ETF candidate at the top of the home page, I will collect the worksheet data as follows:

• Returns: In the left menu click "Performance." Scroll down and you will see the numbers needed to fill in the three "Returns" columns of the worksheet. Keep in mind that many ETFs are relatively new and will not have a 3-year returns number.
• Risk: Click "Risk" in the left menu and look for "Standard Deviation." This is a measure of the ETF's volatility. The higher this number, the riskier the investment. Note that this number is typically based on 3 years of returns data and may not be available for newer ETFs.
• Expenses: This number represents an expense charged to you by the issuers of the ETF; it comes off your total return, so the lower the better. To find expenses, click the "Profile" menu item and scroll down the page. Look for "Fund Operations" in the right column. Some ETFs show N/A on the Yahoo site. If this is the case, go to www.morningstar.com, enter the ETF symbol, and look for "Expenses" in the menu.
• Average Volume: You will find "average daily volume" by clicking the "Summary" menu item. ETFs with low volume have a large bid-ask price and are more subject to dramatic price moves, so look for one that trades at least 300,000 shares per day.
• Fund Summary: Finally, click the "Summary" menu item and read the "Fund Summary" information in the right column to make sure you understand what the ETF holds.

With the target market building process in place, let's begin with the gold building block. The other target market building blocks/asset types will be discussed in Lessons 4 through 7.

Why Buy Gold?

Investors buy gold for a lot of reasons. In general, it is seen as a "safe haven" investment when the economy, equity markets, and even world events are in turmoil. Here are several specific factors that can cause the price of gold to rise:

• The stock market declines and money flows into gold as investors adopt a more defensive position.
• U.S. inflation increases.
• The U.S. dollar weakens.
• Negative world events occur such as war, terrorist attacks, or natural disasters.

The fact that gold has intrinsic value gives people confidence that its value will be retained in the face of negative events that could cause other asset types to decline.

These are "macro" factors that you should take into consideration when deciding whether to place a gold ETF in your portfolio. We will also, later in this lesson, look at "micro" factors such as the current price trend before we decide to buy gold at the current time.

Finding Gold-Related Investments

Now we need to find gold-related ETFs to evaluate as candidates for the target market segment of the portfolio. There are basically 3 categories of gold investments, as shown below, along with related ETF symbols:

Gold Bullion: GLD, IAU

These two ETFs represent ownership of one-tenth of an ounce of gold bullion. This category of ETF is the most direct and uncomplicated way to place gold in the portfolio.

Gold Futures: DGL

This ETF tracks a Deutsche Bank Commodity Index composed of futures contracts on gold. Futures contracts enable companies and other buyers to lock in prices for gold at a future date. These contracts are traded on commodities exchanges. While this ETF closely tracks the current price of gold, it is not a "pure" gold investment. Futures contracts are influenced by a number of factors, including the fact that they have expiration dates and they are also often subject to rampant speculation.

Gold Mining Stocks: GDX

This ETF tracks an index that includes stocks of gold mining companies. Since the price of this type of ETF is dependent on a host of factors related to company risk and general economic conditions, its price is often influenced more by general stock prices than the price of gold bullion, so I will not include it in my analysis.

The Gold ETFs I will use for further analysis are GLD, IAU, and DGL.

Collecting Data

Using the Web resources and process discussed above in this lesson, I collected the following data for my gold ETF candidates. Keep in mind that this will not be current data as of the time you read this. Complete your own worksheet using current data.

Analysis and Selection

Several points are worth noting here as we look at the data. First, the futures-based DGL is too new to have 3-year data, so we do not have a risk figure as standard deviation is calculated based on 3 years of return. Another negative for DGL is its low volume. The two bullion-based ETFs have virtually identical returns and expenses. The risk of IAU is slightly higher. A major benefit of GLD is its high volume, making the bid-ask spread smaller. Based on this quick analysis, I will select GLD as my gold ETF. Now let's see if this is a good time to buy it.

Price Chart Analysis and a Trading Plan

Following is a simple 6-month price chart of GLD as of the time of this writing. The line shows daily closing prices for the time period. Obviously, the chart you view will look different, so simply take note of the analysis methodology described below and apply it to a current chart for GLD.

There are many places on the Web where you can create this chart. A site that is convenient to use is the one at finance.yahoo.com, the same site I used to collect the worksheet data. Simply click the "Basic Chart" menu item and then click "6m" for the time period.

Chart Analysis and a Trading Plan

When viewing a chart, we need to look at the following items.

The Trend

We do not want to buy an investment that is clearly trending down. In this chart, we see that the overall 6-month trend is positive. In the last month it has been bullish, and only in the past few days has a minor pullback occurred. Overall, this chart shows a positive trend for GLD, and I will decide to buy it at the current price of $94.

Exit Points

We will not simply "buy and hold" investments in the target market portfolio segment. We must reduce risk by creating a trading plan that consists of price exit points for either stopping losses or to taking profits. To determine a stop-loss price, I look on the chart for a point of price support, that is, a level at which the price tends to "bounce" up. Here, one seems to exist at $85. I will use this price as my initial stop-loss exit point. If the price goes below its support level, this may signal the start of a major price decline, and I want out.

Now I must ask myself at what point would I be happy to take profits. Here, I take into consideration the market factors that were discussed previously. Current news reports indicate to me that inflation is looming and the dollar is weakening. So I believe there is potential for the price to go above the $97 price point, which seems to be a resistance level on the chart, that is, the level where the price seems to "bounce" down. I will therefore set my take-profit price point at $100.

The Trading Plan

With my exit price points set I am now ready to implement a trading plan. In the plan I will use a Trailing Stop, an order type that is offered by most online brokers and is explained below. Here are the elements of my GLD trading plan.

• Purchase Price: $94. This is the current price market price as shown on the chart.
• Trailing Stop: -$9. This order type and specification tells my online broker's system to sell my position in GLD if the price drops by $9 from the highest price it reaches during the time I own it. Let me explain. If GLD immediately drops by $9 to $85, my initial stop-loss exit price, then my position is sold. The unique thing about a trailing stop, however, is that if the price of GLD goes up, the stop price goes up with it. But once it goes up, it never goes back down. So, if GLD goes to $96, the stop-loss price goes to $87, maintaining the $9 drop specification. If GLD then goes down to $93, the stop-loss stays at $87. If from there GLD goes to $100, the stop-loss goes up to $91. You can see that a trailing stop lets you lock in profits on the downside but allows profits to run! This is an amazing tool.
• Take-Profit Price: $100. Here, I will elect to simply set an automated e-mail alert at the take-profit price I have set. Any online broker should give you an "alerts" feature that allows you to do this. Now if GLD hits $100, I will get an e-mail alerting me to this fact and I can look at the chart again. If I see the trend flattening out, I can sell to take profits. If, however, I think there is more room to grow, I can simply "tighten" my trailing stop. I may decrease it from -$9 to -$3, for example. By doing this, I lock in profit and still can take advantage of further price increases that may still occur and with less risk.
• Time Stop: 30 Days. As a final element of my trading plan I will make a note on my calendar that if neither of my exit prices is hit within 30 days, I will reexamine the price chart and tighten my exit prices. Otherwise, this is dead money and will not help me achieve my overall portfolio return goals.
• Trading Plan Summary. This is my trading plan for GLD. I implement each element of it at the time of purchase. Two actions are all that are required. The first is placing a "buy order" with my online broker using a trailing stop. The second entry is setting a take-profit e-mail alert. There is no trading commission associated with alerts. Now I simply sit back and let the trading plan do its work. If the stop-loss condition is hit, my position is automatically sold. If I get a take-profit alert, I simply look at the chart and decide whether to sell my position or to tighten my trailing stop parameter and increase my take profit alert. If my time stop is hit, I either sell or tighten my exit points. Using this type of trading plan that limits losses and lets profits run maximizes my potential for making money on each asset that I buy for my target market segment.

Allocating Money to the Gold Building Block

Of course, I need to decide how much of my investment money to dedicate to this purchase. But I can't do that until I have performed the same analysis as described in this lesson on all of the target market asset types. I will be prepared to assign allocations in Lesson 8 of this course.

Extra Credit: Using Short ETFs

As you learned in Lesson 2, where we built the core segment of the portfolio, there exist "inverse" ETFs that go up in value when the underlying asset value goes down. Two inverse ETFs that exist for gold are the following:

• DGZ: This is a "single" inverse ETF that theoretically goes up in value at the same rate as gold goes down.
• DZZ: This is a "double" inverse ETF that theoretically goes up in value at 2´ the rate as gold goes down.

These are investment options that you can use if your analysis of market conditions and the current price chart for gold leads you to conclude that its price trend is heading down. Should you choose to buy one of these inverse ETFs, make sure you put in place a trading plan as discussed above, just as you would for the purchase of a "long" ETF.

Our Current Portfolio

Taking into consideration the asset classes we decided to buy for the core segment of our developing portfolio, as discussed in Lesson 2 and the target market segment we started in this lesson, here is the current status of the portfolio we are building.

*Note that final allocations will be determined in Lesson 8 after we have selected all of our investments.

Summary

In this lesson, I have explained the purpose and the structure of the target market segment of the portfolio. Here, we will consider 5 asset types as unique portfolio building blocks. In this lesson, I have discussed the first of these asset classes: gold. You learned the factors that affect the price of gold, how to find gold-related ETFs, how to collect and compare data for each, and how to select the "best" ETF for your portfolio. Then I showed you how to view and analyze a price chart to determine if now is a good time to buy this asset type and, if so, how to implement a trading plan that sells to stop losses or to take profits.

Preview of Next Lesson

In Lesson 4, we will continue building our target market segment with an energy investment.

J. K. Lasser members are eligible to enroll in the National Association of Online Investor "Individual Investor Certification Program" at a significant discount. All students of this course may also enroll in the NAOI "Investing Basics and Creating Your Unique Plan" course for free. Click here for details.