Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Diversifying Your Portfolio
12/27/2011 11:00 am EST
Market strategist A.J. Monte discusses how he suggests investors can diversify their portfolio through ETFs, as he feels many portfolios are not adequately diversified.
A.J., as we're talking we've seen a period of enormous volatility in the markets. Investors have gnawed their fingernails down to the bone.
People don't know what to do, and obviously people talk about diversification. You have a way of doing it with ETFs, right, that you think limits risk and gives people exposure to a lot of different markets. Why don't you talk about that a little bit?
One of the reasons I think it limits risks is because the ETF itself is like a mutual fund if you will. Let's take the Diamonds Trust (DIA) for instance.
In most ways it's like an index fund for the most part.
Yeah, we don't have to get specialized, although there are grain ETFs and oil ETFs or HOLDRs and such. But what I've seen over my years of experience here is a lot of investors who get so entrenched in investing that if you were to dissect their portfolios and pull them apart, you'll see that most of their positions would resemble a lot of the ETFs that are out there.
Interesting. Does that mean people who'd own individual stocks as well, or people who'd own mostly funds?
Individual stocks...and also if you throw the funds in there, there are some people that are overdiversified to the point where they have a mutual fund here; they have some Dow component stocks over here; and they're so overextended in all areas that they're really not in any directional trend. They're just in the market all around.
Right. So how do you address that with ETFs?
Well, it's also good to do some screening. ETFs don't have the fundamentals an individual stock would, although the managers are responsible for taking care of that and getting in and out of their positions or balancing them.
However, the ETFs themselves are very technically driven. I'm not going to say I don't use fundamental analysis, because I do. The fundamentals tell me which ETFs to get into or which stocks to get into. But it's the technical charts that tell me when to get in and, more importantly, when to get out.
Let's say somebody wants to play a trend, for example—let's say, God help us, social media. They say, "Oh, this is going to be hot"...never mind the private market has driven these things up hugely.
Yes and no. Again, that's still an emerging market in my opinion. It's so new, social media, with a lot of people going out there and looking. Hey, I'm going to go buy Facebook or I'm going to go buy Google (GOOG).
If you look at some of these prices, they're out of reach for most people, so the average investor isn't going to have enough buying power to participate. So the ETF—and I don't have to be specific here—just in general, the ETF is priced at a point where it will allow the average person and even the advanced investor or trader to participate.
Most of the ETFs out there have a very robust and diversified option chain attached to them, so if someone wants to do a conservative option play they can still get a good return on investment without risking too much in their portfolio.
Also very quickly, I mean obviously you don't have to pick winners and losers then, because the ETF has both the winners and the losers.
So you may not get as much upside, but you certainly limit your downside, right?
Absolutely. It's not a hedge fund, but it's something that'll help spread the risk out. So if you have one of the Dow components and you're trading DIA, you could have one of the Dow components take a hit on a downgrade, maybe because of a bad earnings announcement, but yet it's not going to hurt your portfolio that much.
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