How to Deal With a Correction: Give me an E, Give me a T, Give me an F

The broad market has yet to go really parabolic which makes me think this rally hasn’t fully run out of steam, but it’s also no prerequisite to get a good 5%+ correction going.  We don’t want to be reactive when a sell-off takes hold, so let’s mentally prepare to deal with this eventuality. 

Now let’s begin with some fun ETF education.  There is so much to know and so much fantastic information out there.  You may be wondering where to get started and what ETFs make sense for you.  Start here: http://en.wikipedia.org/wiki/Exchange-traded_fund.  Then read on:

  1. Use Yahoo’s ETF tool to see funds in various categories: finance.yahoo.com/etf/browser/mkt
  2. Popular sector and US index ETF creator: www.spdrs.com/
  3. Popular Global/foreign ETF creator: www.ishares.com
  4. Leveraged ETF firm: www.direxionshares.com/etfs
  5. List of leveraged ETFs created by different firms with different levels of leverage: http://etf.stock-encyclopedia.com/category/leveraged-etfs.html
  6. Very cool firm creating equal weighted ETFs which are a great complement to any portfolio (this is how you can remove the Apple effect from your Nasdaq/Technology sector investments):  http://www.rydex-sgi.com/products/etfs/content/equalweight.shtml

Whether you’re up 10% or 25% so far this year, it’s now time to play defense for a bit to protect those gains.  Please eliminate any and all leverage.  Maintain exposure to core broad market ETFs like SPY, RSP, IWM, and EFA.  If you have extreme exposure to a single sector ETF like QQQ, XLF or XLE, tone it down.  Emerging markets bets like VWO or EEM can remain, but take them down to a maximum total of 10% of your portfolio.  Raise 5-15% cash if you feel the need now and we will add exposure to some leveraged ETFs like UPRO, TQQQ and EDC as opportunities present themselves during any correction.  Once a correction is underway, we will discuss how investors with higher risk profiles can use a very small short-term volatility ETF position in TVIX to enhance returns.

My ETF portfolio is up 18.4% year-to-date thanks to some well-timed leverage, exposure to the tech-heavy Nasdaq 100 Index and emerging markets bets.  Sure individual stocks like Bank of America, Caterpillar and Apple have posted 20-45% returns, but don’t get green with envy.  They come with stock specific risk trumped by the diversification most ETFs offer.  Want to analyze your performance year-to-date like the pros?  Comparing your % return to the S&P 500 Index or your next door neighbor is a good start, but you should learn to measure your risk-adjusted return like an institutional investor. 

Let’s start with the basic Sharpe Ratio: (rp – rf ) / sp::  In this equation, rp = the average return on the portfolio; rf = the risk-free rate; and sp = the standard deviation of portfolio return.  The Sharpe measure is found by dividing the portfolio risk premium, or the return on the portfolio minus the risk-free rate, by the standard deviation of the portfolio.  Compare that to the market’s ratio or those of your friends.  You will need daily values for your portfolio to do this in excel – it’s very simple, just make one of your financier or engineer friends dinner and force them to help you with the calculations.  Once you figure out Sharpe ratios, look up Treynor and Jensen ratios – these are other ways to measure risk-adjusted returns.  Big returns aren’t very useful if they fall flat on a risk-adjusted basis.

Enjoy the long weekend and remember to protect the hard-earned gains achieved during this wonderful rally.

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