What's your favorite stock?
Seems like such a simple, harmless question, right? But suggesting the one perfect stock that's good for any portfolio is a pretty tall order. It's no wonder Warren Buffett takes a pass on throwing out individual stock ideas.
While it's fun to trade individual stock tips and track their daily fluctuations, it's better to look beyond individual stock performance and focus on constructing market-beating toolboxes.
Huh? What's a toolbox got to do with investing?
Every investment is a tool designed to help us earn our desired returns. The combination of all of our investments -- our portfolios -- shows us what tools we really have in our toolboxes.
Just as a man with a hammer sees everything as a nail, having only stocks in our portfolio toolbox limits our ability to tackle uncooperative markets. That's why it's important fill your box with the kind of gear that can keep your profits humming.
One increasingly powerful tool is exchange-traded funds ("ETFs"). What are ETFs? Simply put, imagine that a mutual fund and a common stock got together and had a baby.
Like mutual funds, ETFs can offer investors both broad and narrow exposures to specific industries, sectors, or investment strategies. However, since they trade like stocks, ETFs are also an accessible, liquid, and tax-efficient way to plug those holes of fear in your portfolio.
See inflation around the corner? Maybe the SPDR Gold Trust (NYSE: GLD ) is for you. Oh, I'm sorry -- you think gold prices are too high? Maybe you want a total commodity ETF like Fidelity Global Commodities Stock Fund (NYSE: FFGCX ) ? Have a very specific diversification or hedging fix? Don't worry, there's an ETF for that.
For example, back on April 1, Global Gains' Tim Hanson recommended Philip Morris International (NYSE: PM ) , a solid company whose stock had sold off because of its large European exposure. However, Tim also believed the stock could fall further if the euro continued to slide. He thus recommended that investors hedge their purchase by buying an offsetting amount of ProShares UltraShort Euro (NYSE: EUO ) , an ETF that rises as the euro falls. Beautiful move.
While options can appear to be scary at first, they're probably one of the most underused tools for cautious investors. While the lion's share of reporting on options tends to focus on the more speculative trades, there are numerous strategies well suited for the conservative investor.
One popular options strategy involves writing covered calls. In this scenario, you own shares of a company that you believe in but that you also think will be stagnant going forward. You can write calls on the stock for a predetermined sell price. That gives the buyers of those calls the right to buy them from you at that predetermined price while the option is current.
If the price goes above the target price, you're obligated to sell at the predetermined price, and you forfeit any profits above it. However, you've already earned a little more through the calls itself, offsetting any forfeited gains.
If the price stays steady, you keep your shares as well as the income the calls generated.
In other words, covered calls are the ideal tool for investors who want to essentially lower their cost basis on stagnant stocks in their portfolio.
Making stocks pay dividends
Covered calls can also be used to goose the near-term payout of stocks you already own or make stocks that don't pay dividends synthetically do so.
Take, for example, Wal-Mart (NYSE: WMT ) , which currently pays a 2.4% dividend and sits roughly halfway between its 52-week high and low. The company has held up well during the recession, but at current prices the stock is neither a screaming buy nor sell. Assuming Wal-Mart's stock stays range-bound over the next six months or so, selling a covered call could reap you an almost 5% payout on top of the dividends the company already pays out.
Or what about Cisco (Nasdaq: CSCO ) ? Although the stock has pulled back recently, shares appear reasonably priced. And like many tech companies, Cisco doesn't pay a dividend. So, if you own Cisco shares, believe it's fairly priced, and would like to get paid a dividend, writing a covered call may be for you. Selling a January 2011 covered call would create an artificial dividend of about 10% for a stock that doesn't even pay one!
The Foolish bottom line
We don't advocate using ETFs or options to speculate, but we believe investors can use them intelligently to help create a portfolio that is relatively resistant to the market's temperamental whims.
How do we know? Jeff Fischer and company at Motley Fool Pro have built a ridiculously impressive track record using stocks, ETFs, and options -- they've posted better than 20% returns while still sporting a hefty cash position. If you'd like to find out more -- as well as get a free report with five strategies for growing your wealth in a volatile, range-bound market -- just enter your email address in the box below.