How To Diversify Your Portfolio With A Single ETF Purchase

No matter whether you are a season investor or beginner just getting started in the stock game, there’s a popular investing option that might just suit your portfolio diversification needs.

These high efficiency products called Exchange-Traded-Funds (ETFs) are great for diversifying your portfolio with a single purchase. Plus they are low cost and tax efficient.

What more could an investor ask for right? Besides a self-trading robot I don’t think there’s much else.

Diversification In The Old Days

Before ETFs came along an investor would literally have to individually purchase each stock in a wide array of industries or sectors to get complete diversification. This could take a while to accomplish let along the cost involved in owning all these companies at various prices.

Today the idea of building a portfolio like the one above sounds “caveman-ish” to investors. ETFs allow you to quickly and easily purchase a fund that already tracks or mirrors certain industries and sectors (even broader country markets from around the world).

The New Age Of Investing

As an example, let’s take the highly traded QQQ. The “Q’s” as they are called on the street track the NASDAQ-100 Index and is one of the most highly traded ETFs with nearly 99.7 million shares exchanged each day.

By purchasing a share of the QQQ you are automatically granted exposure to the entire basket of NASDAQ-100 stocks. You are already diversified across different sectors including; hardware, software, telecommunications, biotechnology, and transportation. All this with a single purchase!

So each day, the collective value of the individual companies causes a price fluctuation in the underlying value of the QQQ. But with 100 companies, no one single company is going to cause you to go broke if the stock crashes. Plus the index is capitalization weighted so the larger, more stable companies get a larger share of the pie.

The QQQ is also eligible for retirement accounts including 401ks and IRAs making it very attractive for long-term value investors.

Beware Of Inverse, Double & Triple Funds

You may have already seen tickers for FAZ and FAS for example which are what I like to call exotic ETFs. FAZ is the 3X Bear fund that profits 3 times as fast when financial stocks fall. FAS on the other hand is a 3X Bull fund that profits 3 times as fast when financial stocks rise.

With just 1 purchase you can be both highly leveraged and either short or long a massive sector of the economy instantly. Kind of cool but also a little scary for some traders.

My advice remains the same . . . these types of exotic ETFs are neither good nor bad. You just have to understand how they are calculated and trade them sparingly.

Top 10 Most Traded ETFs

Just for curiosity, I pulled a list of the top 10 most traded ETFs from 2011. Ironically enough there are some surprises in here to, including TZA and EFA.

While the universe of ETFs is constantly growing, you should try as best you can to focus on those with higher volume. The extra liquidity will help you get in and out fast (and at much smaller bid/ask spreads which keep more money in your pocket).

  • Paul OBrien

    Kirk, I've got one contract of FAZ ATM calls with January expiry. Actually thinking of doing a bull call spread with it next week if things tank. Also have a few shares of TZA. I think they are a great way to hedge given the current state of the world. I am very bearish about the overall world situation, so it's great to have these choices.
    I have a friend who has been trading these for years and always makes money. He buys when they get low enough and inevitably they seem to go up.

    • Kirk

      Thanks for the comment Paul - I do think that these major ETFs can be a great vehicle for trading. My favorites are the EEM and USO right now.