How to Murder Your Portfolio

Suppose you got a windfall of $1 million. That would be pretty cool, wouldn't it?

But $1 million really isn't all that much money anymore, and given how things have gone for stock portfolios since 2007, you may feel like you have a lot of ground to make up. So maybe you should invest that million dollars in something that will give us a lot of growth in a hurry.

For instance, say you bought one of those leveraged ETFs that give you two or three times the gains (or pains) of an index or sector. A month later, you're up 50%. $1.5 million! We made half a million bucks in a month!

After that performance, we decide to stick with that fund for a little longer. Who wouldn't? Alas, market conditions change, and at the end of our second month we're down 50%. Our balance is $750,000. We didn't just lose our first month's gains, we've lost some of our principal, too. Bummer.

What do you think? Should we stick around for a third month?

What's your point?
I've got a couple. First, it's amazing how many people forget this simple math: Up 50% and then down 50% means you've lost 25% of your original investment. Keep that back-and-forth grind up for awhile, and you'll be lucky to have enough of your million left to buy lunch.

Second, and related: Making up lost ground with leveraged ETFs seems to be a popular sport these days, but that doesn't mean it's a healthy one. I suspect that many of the investors who buy these things don't really understand how volatile they are, even if the overall market trend is in their favor. It's common to be up a lot one day and down a lot more the next -- a tendency which pushes many folks' panic buttons, given the human brain's hardwired propensity to buy high and sell low.

As Foolish fund guru Amanda Kish said recently, this kind of leverage seems more like gambling than like investing.

But they're not always bad, are they?
Leveraged ETFs can be useful in some situations, but they're almost always short-term situations. As we've said before, these things aren't designed for long-term buy-and-hold investing; they're designed for trading. But that doesn't mean they're for day traders only. Sometimes even long-term investors want to get a little extra from a big market move, or would like an "emergency brake" available to hedge their portfolios when the market moves sharply against them.

Here's an example of the "emergency brake" thing: I happened to have a sizeable cash position when Lehman Brothers failed last fall, triggering the Great Panic of 2008. This wasn't planned -- I had recently sold a couple of stocks that had done well and hadn't yet found anything I liked enough to buy -- but it was convenient. I threw it into an ETF called Proshares UltraShort S&P 500 (NYSE: SDS  ) , which is a double-leveraged short of the S&P 500 index (in other words, for every $1 the S&P dropped, the ETF was supposed to gain $2).

In practice it didn't quite work out to a 2:1 ratio, but it did exactly what I'd hoped, which was to act as a brake on the falling value of my overall portfolio. I ended up losing about 10% over that wretched period last fall -- but if I'd kept that balance in cash, that number would have been 30% or more. I was happy to have the profits, but I bailed out as soon as the market's direction became less clear.

A better approach
Do you think oil and natural gas prices are a sure thing to rise over the long haul? That seems a reasonable bet, though it's easy to envision situations where they go way back down before resuming an upward trend. I can see someone thinking they'll make a fortune by buying the double-leveraged PowerShares DB Crude Oil Double Long ETN and sitting on it until oil skyrockets again.

If you time it exactly right and sell at exactly the right moment, that might work out; but if you buy it and forget about it for a few years, you might come back to find that the up-and-down gyrations have ground your original investment into dust -- even if oil is $300 a barrel.

I say you're better off doing one of two things: Sticking with the energy example, you could either buy an unleveraged ETF that is directly tied to energy prices -- something like the U.S. Oil Fund (NYSE: USO  ) -- or buy stocks in companies that stand to benefit from rising oil or gas prices, like any of these:

Stock

CAPS Rating
(out of 5 stars)

3-Month Return

EnCana (NYSE: ECA  )

*****

39.6%

BP (NYSE: BP  )

*****

29.5%

Total SA (NYSE: TOT  )

*****

21.7%

Nabors Industries (NYSE: NBR  )

*****

83.2%

Contango Oil & Gas (NYSE: MCF  )

****

34%

Source: Motley Fool CAPS, Yahoo Finance.

By buying stocks, or an ETF that is solidly linked to an index or a commodity's price, you're buying something real. You're investing, rather than gambling, and while you might not triple your money in a week, you greatly reduce your chances of losing your shirt -- and increase your chances of being able to actually spend that money somewhere down the road.

For more on making smart retirement moves, read about:

Looking for ways to get the most out of your long-term investment portfolio? Read Rule Your Retirement for 401(k)-friendly advice on getting the most bang for your invested bucks. A free trial gives you full access for 30 days -- and costs absolutely nothing. Click here to get started now.

Fool contributor John Rosevear owns shares of BP and Contango. Total SA is a Motley Fool Income Investor recommendation. You can try any of our Foolish newsletters free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 30, 2009, at 9:34 AM, bobbyabull wrote:

    The author, while honestly trying to help, is pretty much totally incorrect here. All he has done is discover a counter intuitive quirk of mathematics. Lets examine this problem from another angle: suppose I decide to invest $10 in an S&P 500 index fund tomorrow. When the market opens and I buy one share of SPY, the S&P is sitting at an even 1000. We then have a huge 50% rally (I'm obviously deliberately keeping the numbers simple) - so now the S&P is at 1500 and my 1 share of SPY is worth $15. BUT, the worm turns and the market drops by 50% just as quickly! Now my index fund is only fetching $7.50 on the open market. We went up 50%, then down 50%, and I've lost $$. Why? Because half of 1500 is 750, not 1000 which is where the market stood when I bought into it. Another 50% move up would result in S&P 1125, with the subsequent 50% down correction dropping the index to only 563! Over time, 50% up and down moves make the base number smaller and smaller. This has nothing to do with whether or not an ETF employs leverage (or for that matter whether you're even an investor!) it is just simple math. Having said that, what SDS does do is allow you to get more "bang for your buck" and free up capital. Think the market is overbought? You can put $500 in SDS or $1000 in SH - your choice. Both will net the same result. And, as always, average into these instruments as their prices decline and scale out on the way back up. The author's example implied a buy-and-hold strategy that has basically been debunked anyway. Why would anyone continue to carry a large short position in their portfolio after the market has significantly pulled back? You've got to take profits sometimes. Trade around a core position people - and good luck out there!

  • Report this Comment On May 30, 2009, at 4:21 PM, TMFMarlowe wrote:

    Oh, my. Where do I start?

    Buy and hold "debunked"? By whom? Where? Give me a cite -- not a sound bite -- and we'll talk.

    And yes, what I'm saying is "don't HOLD these things in a volatile market or you'll get ground up." (And to novice investors, don't think you're going to make up the 40% you lost last year by sitting in SSO or whatever while you wait for the recovery. I've heard several stories of people trying to do just that and getting burned. That's what prompted the article.)

    You also said "what SDS does do is allow you to get more "bang for your buck" and free up capital." My point is that yes, you get lots of bang for the buck IF you time your trades into and out of the swing correctly... but most people don't.

  • Report this Comment On May 31, 2009, at 1:25 AM, bobbyabull wrote:

    Mr Rosevear,

    I thank you for the reply. I love this website and have learned an awful lot from it and it's contributors. I may have phrased my thoughts poorly. Having read your response to my comment I now believe that we more or less agree - there is no real argument here. As far as buy and hold is concerned, I'm sure you know this already, but the S&P was at 1327 on 6/1/1999. So for the past decade I suppose some would opine that the strategy hasn't worked all that well. Similar sentiments are echoed on CNBC from time to time.

    Regardless, I appreciate the help and look forward to enjoying your future columns.

    Bobby Abutel

  • Report this Comment On June 01, 2009, at 7:15 PM, boxmasterer wrote:

    Found this interesting and thought others may enjoy it if they haven't already seen it...

    SIMPLICITY AT IT'S BEST

    This is from an article in the St. Petersburg Times

    Newspaper.

    The Business Section asked readers for ideas on "How

    Would You Fix

    the Economy?"

    I think this guy nailed it!

    Dear Mr.. President,

    Please find below my suggestion for fixing America's

    economy.

    Instead of giving billions of dollars to companies that

    will squander the money on lavish parties and unearned bonuses, use the following

    plan.

    You can call it the Patriotic Retirement Plan:

    There are about 40 million people over 50 in the work

    force. - Pay

    them $1 million a piece severance for early retirement with the

    following stipulations:

    1) They MUST retire. Forty million job openings -

    Unemployment fixed.

    2) They MUST buy a new American CAR. Forty million cars

    ordered - Auto

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    Housing

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    It can't get any easier than that!

    P.S. If more money is needed, have all members in

    Congress and their constituents pay their

    taxes...

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