The ETF

We have talked about the benefits of diversification before.  This technique should be used in your overall portfolio and within each asset class in your portfolio (meaning you should have a mix of stocks, bonds, etc. and diversification within stocks, within bonds, etc.)  If not, you might end up with the diversification they have in the cartoon.

So since we are on the topic of stocks, I am going to be introducing the exchange traded fund (ETF) which is an easy way to diversify your stock holdings.  The ETF is a security that tracks an index (a basket of different stocks or other assets) but trades like a stock.  You get the ability to buy it like a stock or short sell it and some of the advantages include lower fees than mutual funds (which we will talk about later).


A very common ETF is the SPDR ETF (ticker: SPY) which tracks the S&P 500.  The S&P 500 is one of the most common stock market benchmarks (most people look to how the index is performing to get an idea about the economy as a whole or the stock market as a whole).  It is a basket of 500 stocks chosen for market size and industry groupings.  It is meant to reflect the risk/return characteristics of large-cap stocks.

The variety in the S&P 500 makes it a good investment since you pay commission once (we'll talk more about the mechanics of investing later) and you get a basket of 500 different companies.  This means that individual risk of bad news for a single company is mitigated along with bad news for a specific sector.  Some components in the S&P 500 include big names like Amazon (AMZN), Apple (AAPL),  Chevron (CVX), General Electric (GE), and Kellogg (K).  For example, if oil prices drop a lot, holding energy companies like Chevron may be very bad, but holding the S&P 500 will receive very little of that effect since energy stocks are only a portion of the basket of stocks it holds.

Most money managers use the S&P 500 as a benchmark to compare their own performance.  And most money managers fail to come up with a portfolio that is able to beat the S&P 500 year after year.  Some passive investors who believe in the benefits of holding a wide array of stocks but don't care for extraordinary gains choose to just invest in the S&P 500 through an ETF like SPY (although there are other ETFs that track the S&P 500 like a Vanguard fund).  Most investors think about the average return of the S&P 500 to be around 8% over the course of a year, although this number does fluctuate year to year.  So far in 2011, the S&P 500 has experienced a 5.84% gain.  Last year in 2010, the S&P 500 rose by 12.78%, and the year before by 19.67%.  Of course, these extremely high numbers followed the financial crash of 2007 where the market fell by about 40%.  Of course, these past few years may be simple outliers in the long run so I wouldn't pay too much attention to them.

As always, it is important to do your own research when deciding on your investments to fit your own circumstances and goals.  The ETF is a powerful tool for investors today and can be a great asset to younger adults who have several years to allow for a portfolio to grow.