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Stop Playing the Loser's Game

The number of ways you can play the market today is overwhelming. As if the huge stock universe weren't enough, there are also bonds, futures, options, spots, and other investment vehicles to consider.

Each serves a useful purpose, if you implement them prudently. For instance, when used properly, derivatives such as covered-call options can help mitigate risk and generate income.

Unfortunately, retail investors often misuse such vehicles. They end up playing a loser's game in an attempt to get rich quick.

Dumb it down, double your dollars
Historically, if you wanted to trade individual options, trade on margin, or play the foreign exchange markets, you'd have to fill out special forms with your broker, affirming that you understood the added risks and had adequate net worth to sustain large losses.

This "barrier to entry" for small investors was an opportunity for financial firms, which packaged such exotic instruments to investors in the form of specialized exchange-traded funds (ETFs).

Today, you don't need adequate financial knowledge or net worth to get in the game. You just need a brokerage account. Want to play the gold market? There's the streetTRACKS Gold Shares ETF. How about shorting the Dow, going long on the domestic Swiss market, or betting against the U.S. dollar? There are ETFs out there for those purposes as well.

And it appears that retail investors are taking the bait. According to Morningstar, UltraShort QQQ ProShares ranks among the top five most-traded ETFs. This one uses leverage to bet against the Nasdaq 100, which includes stocks such as (Nasdaq: BIDU  ) , SanDisk (Nasdaq: SNDK  ) , and eBay (Nasdaq: EBAY  ) .

Also included in Morningstar's list of heavily traded ETFs is UltraShort S&P 500 ProShares, which bets against U.S. large caps, including NYSE Euronext (NYSE: NYX  ) , Automatic Data Processing (NYSE: ADP  ) , and Valero (NYSE: VLO  ) .

This isn't to say that these specialized ETFs aren't useful to professional investors -- and institutional managers. But retail investors face a simple problem: Over the long term, stocks go up, and ETFs that short them will offer poor returns. So to make money using these vehicles, you need to be an active trader who consistently calls the market's gyrations correctly.

That's an unlikely combination. The more decisions you make, the more likely you are to decide incorrectly.

Play the winner's game
If you aim to accumulate wealth over the long term, your best bet is to go long on a diversified portfolio of stocks and bonds, in percentages consistent with your time line and risk tolerance.

For some, this approach might mean putting together a proper allocation of index mutual funds, such as the Vanguard S&P 500 Index and Vanguard Total Bond Market Index. For those who want to venture beyond index funds, consider hand-picking a portfolio of great stocks worth holding for the long term.

If you fit the latter mold but aren't sure where to start, consider the Fool's Stock Advisor service. That's where Fool co-founders Tom and David Gardner look for stocks that trade at reasonable prices, and for companies that are efficient operators with wide market opportunities.

Since the newsletter's inception in 2002, Stock Advisor recommendations are ahead of the market by nearly 42 percentage points on average. We offer full access to Tom and David's past and current picks with a free 30-day trial.

This article was first published Jan. 29, 2008. It has been updated.

Todd Wenning wonders whether there's an ETF that shorts The Hills on MTV. He does not own shares of any company mentioned. NYSE Euronext and are Motley Fool Rule Breakers picks. eBay is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy is, like, so cool.

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