Diversification and Indexing

Editor's Note: You can find our complete library of free investing articles here.

Diversification is one of the only no-cost benefits available to investors. Although diversification isn’t difficult, it does require some preparation and planning. But the effort is well worth it, and not diversifying can be devastating. You’ll enjoy a less volatile equity curve, smooth account growth and smaller draw downs than otherwise possible.

Surprisingly, self-directed investors often ignore diversification as they tend to move from a single, discrete opportunity or trade to another. Self-directed investors do this for two reasons:

The first is a tendency to seek short-term trades. This not only increases trading costs through spreads and commissions, but the profit advantages are often dubious.

Second, there is a perception that options trading is for aggressive traders only, and therefore a conservative tool like diversification is incompatible with options strategies. Clearly, both issues are due to misconceptions about trading and investing as an individual.

In this section, we plan to continue showing why effective portfolio management techniques belong in every portfolio, regardless of your risk tolerance or long or short term bias.

We recommend that you use options to increase the risk control already in place in your well diversified stock portfolio, rather than creating a second “options portfolio” which is managed separately from your stock portfolio. This creates management efficiency and provides risk control benefits that are not possible otherwise.

Here are three ways we would implement options to improve portfolio diversification.

Writing covered options:

Writing options against long positions within a portfolio, especially when those positions are showing signs of weakness is a great way to remove volatility from your portfolio.

Investing in options that represent diversified asset classes:

As a stock investor, you have tools available to help you diversify your holdings outside the corporate world. In addition to investing in stocks within different industry groups, you can find great ways to add other asset classes to a stock portfolio through index options. You can add gold, oil, interest rate (bonds), foreign currency and other asset classes to a portfolio within your existing stock and options account to offset some of your market exposure.

Trading options that are inherently diversified:

Index options and options on ETFs often offer diversification inherent in the option itself. Because a stock index or ETF usually represents a large pool of stocks, it makes sense for options traders to prioritize these opportunities over options on individual stocks. A side benefit of many index and ETF options is a tighter spread, which translates into lower trading costs.