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Individual stocks, ETFs and options all offer potential, if you know how to use them. Here’s a primer.
While I cannot discuss specific investment moves I have made or may make in this space, I can share some of the trends I am acting on in the portfolios I manage. And for anyone in my field, has there ever been a better time to do that? I don’t think so. Here’s a quick look at my year so far, regarding how I have navigated the 2020 roller-coaster that is the global stock market.
Stocks and ETFs and options, oh my!
There are many ways to participate in the upside potential of the stock market. Some are geared toward the short-term, some toward the long-term, and everywhere in between. To me, there are 3 primary ways to manage the “offense” side of your portfolio. Which ones you use, when you use them, and in what combination you do so is a personal decision. I will just cover some basics and the trade-offs between them, given today’s gyrating markets.
Individual stocks: portfolio-style
I am not talking about “trading stocks.” Nor am I referring to some “buy and hold” strategy that, as folks are finding out quickly, depends entirely on a bull market being in place (it no longer is).
I am talking about building a sustainable portfolio of stocks, as one relevant method of trying to derive intermediate-term and long-term profits from what the stock market offers. In my view, during normal times, that means 20-30 individual stocks.
The positions are perhaps 2-4% of the portfolio each, when first purchased. Above all, the idea is to create a portfolio that can work together as a team for you, and where “surprises” can be minimized.
Why is this market different from all other markets?
As you know, all stocks carry “stock-specific risk.” That is, company news, earnings announcements, negative developments for its industry or sector and a host of other factors can make any stock vulnerable to a violent price reaction. This has become more pronounced in an era where hedge funds, algorithms, and passive managers dominate daily stock market volume.
These market participants tend to be less concerned with what they actually own, and more concerned with buying according to a very specific set of rules. Or, as in the case of index funds, trading activity is a matter of how much money flows in or out of the fund.
Frankly, in this market environment, it has been months since I have found one individual stock that meets one of my key criteria: I aim to minimize the potential that it can go down 10% from my cost, for any reason. That’s a goal, and in a market that flips around like the current one, no stocks can be expected to deliver on that.
So, instead of the usual 20-30 stocks, I have owned zero for a few months now. I don’t know if that has happened since I started buying individual stocks for client portfolios. But if there is ever a time to adjust your rules for “playing offense,” this is it.
Is that a “market-timing move?” No. I substituted ETFs and call options for where stocks would normally be, in order to limit that stock-specific risk for a while.
ETFs instead of stocks?
I am still quite amazed that despite ETFs being a staple of so many financial advisor-managed portfolios, they are still not that well-known by the investing public. ETFs are essentially like mutual funds, except they trade on the stock exchange (so you can buy and sell them during the day, not just at the closing value each day). There are thousands of them, and they each track an index.
Translated, that means that an ETF is going to own a set of stocks. That provides instant diversification, similar to how mutual funds do. Now, you have to be careful when assuming all diversification works out the same way. For instance, some Oil stock ETFs have probably been more volatile than many single stocks this year.
Still if you can research and allocate among some number of ETFs (3-7 at a time has been typical for me lately), that’s an alternative to that stock-specific risk I noted above. And, you can move between these “baskets” pretty smoothly. Simply put, a smaller number of moving parts in your stock portfolio can be helpful in times like these.
ETFs in Prime-Time?
If you use individual stocks as the Core segment of your hedged portfolio, ETFs can provide a solid diversification component.
I typically use ETFs as “tactical” side-car investments alongside that main stock portfolio. However, this year, they have become what college basketball legend Dick Vitale calls a Prime-Time-Player, or PTP (baby!).
Buying call options: upside potential with less risk
Buying a call essentially gives you the right to buy a security or index at a specified price. In normal markets, call options can potentially be a helpful way to supplement stock market exposure, but with a limited cash outlay. Generally, a call option on a major stock index or market segment should rise in value when the market rises, and fall in value when the market falls.
However, when the stock market is falling 33% in a matter of weeks (as it did in February/March of this year), individual stocks become a “crap-shoot” (and I am not just talking about the casino stocks). And ETFs can play a role, but even modest exposure to the stock market during bearish selloffs can leave you a lot poorer, quickly.
First time for everything
That’s why at one point earlier this year I actually had a portfolio allocation I don’t think I ever had before: my entire “long” portfolio (the part expected to gain when the stock market rises) was in call options tied to a major stock market benchmark. No ETFs, no stocks. Given the overall objective of the hedged portfolios I run, this was not going to be a long-term situation, and it wasn’t.
Like chocolate, vanilla and strawberry…
Still, the take-away from this discussion is that I see 3 basic ways to invest in the upside potential of the stock market. Aim to identify the ones you favor, and develop a “watch list.” Then, mix and match the 3 categories in a way you are comfortable and confident in. It can be a lot of work, but this is your retirement in the balance, right?
If you can orchestrate this, you have likely gained a big leg up in the battle against bear markets. As I see it, that might be the most important skill-set for any long-term investor to develop right now. Because the last thing you want to do now is take it as a given that things will “go back to normal” in the stock market, or otherwise, very soon.
Related: How To Interpret The S&P 500 Rally