The fishing trip to Lake Powell last weekend turned out well. I tried not to think about investing while I was there, but I wasn’t totally successful. I never resorted to checking out current market conditions because I’ve seen too many people who let their moods and emotions be dictated by daily account swings. I rarely take short-term positions, so daily market moves have little impact on my overall investment strategy.

As my son and I walked along the marina between the rows of gigantic houseboats, I could not help noticing that the names of several had investing references. Names like “Winning Portfolio” or “Market Princess” combined with the opulence of the floating mansions left little dobt that the owner experienced some investment successes.

This is really the dream of all investors, isn’t it? We want to buy that special stock, mutual fund, option, etc., that will take off and make us wealthier than we ever imagined. Yet very few investors actually realize that dream. Primarily that is because two of the most difficult choices to make as an investor are when to buy and when to sell. And of those two, selling at the right time is probably much more difficult. Almost every investment will have periods when it makes big gains quickly. Most of us have seen instances where a specific stock goes up 200% or more in just a few days or weeks. We don’t want to sell, because we hope it might be the next Microsoft or IBM and if we sell too soon, we’ll never make enough to buy that fancy houseboat. But most of those stocks that go up quickly come down even faster. If the investor hangs on too long, a 100% gain can quickly become a loss.

I have a friend who is a very successful investor. His philosophy is that any time he buys and investment vehicle, he sets a profit target. In other words, he decided beforehand what a realistic return would be for the position he is taking. That means he does some research ahead of time so he has an understanding about the historical behavior of his chosen vehicle. I can probably explain this better with an illustration.

This is a price chart of iShares MSCI - Brazil Index Fund (EWZ). Over the past three years, this fund is annualizing at a rate of about 110% a year. Most of us would be very happy with that kind of return. The gold line on the chart is the Nasdaq, included just for comparison purposes. The blue line is a 100-day simple moving average of EWZ. That chart shows us that while EWZ has moved up steadily, but there have been some periods of significant drawdowns. These are marked by the red letters.

Someone who purchased this fund in May 2003 would have gained 75% in the first eight months (point A). But over the next six months (point B), more than two-thirds of those gains would have been lost. An investor who bought at point A would have immediately lost 65% of his original investment. The other two downturns shown have not been as prolonged or as severe, but they would still be emotionally wrenching to and investor holding through them. For example, an investor who bought at point C would lose one-third of his investment in the first two months. He would have to hold another four months to make back the money he lost. If he could handle that, then he would almost double his money in the following six months.

Looking at this information gives us some good insight into what to expect if we want to take a position in this fund. First, there will be plenty of volatility. Depending on when we buy, we can expect to start with a fairly significant loss. As long as the fund continues to trend, we can expect good returns. Since 110% a year might not be sustainable, let’s shoot for a profit goal of 75%. We can use the moving average to help us mitigate the possibility or amount of loss and to decide when to buy or sell.

I’ve used green arrows to highlight areas where there are big spreads between the 100-day SMA and the fund price. These usually mark periods where the fund has made a significant advance. We want to avoid buying when that spread is wide, because that increases the likelihood that a correction will soon follow. For example, we would not buy at point A because the spread is wide. We want to buy during periods when the spread narrows. I’ve highlighted those with purple arrows. Buying when the spread narrows does not insure that we won’t experience a loss. If we bought at the first purple arrow after point A, we still would have an immediate loss. But instead of losing 65% from the high at point A we would only experience about half of that loss. You can also see that right now the spread is wide, so we would want to wait for a pullback to buy.

So we buy on a pullback with 75% as our target for profit over the next year. If the fund hits that mark before a year has passed, we probably should consider taking some of our profit off the table then, even if the fund is still trending up. The friend I mentioned above always sells half his position with an investment reaches its target goal. This helps him avoid the dilemma of wondering when to sell. Then he lets the rest ride as long as it trends up.

What if the investment goes against you? In this example, because of the volatility of the fund, we need to be prepared to withstand some significant declines. We’ve seen that we could have experienced a 65% loss at one point. By using technical tools, we should have been able to reduce that by half. So if we are taking a position in this fund, we should realistically expect to be able to handle a drawdown of about 35%.When you consider that in the context of a 300% gain, that doesn’t seem so bad. But actually holding through that type of a dowturn is a gut-wrenching experience.

Today’s market action left us feeling a little of that wooziness. The Nasdaq is still holding above the bottom of the channel that began in January. A move below that support would not necessarily be a bad thing because it would at least allow us to escape from this tight trading range.

We’ll keep our fingers crossed. have a great weekend.