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:

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:

• The biggest threat ever to your retirement.
• The monster that will eat your retirement.
• Where millionaires are turning for help.