The Big Picture for the Week of July 12, 2009

We spent Friday driving up from Newport to Portland and then we hiked around the Pearl District for a while before going the rehearsal dinner (we are in Oregon for a friends wedding). The picture below is of yours truly at a place called Voodoo Doughnut. I know from my wife's love for the show Amazing Race, the one that ended in Portland, it is a famous place.

In the picture I am eating a doughnut that is flavored like an orange creamsicle and it is delicious. Doughnuts can cause all sorts of problems depending on how they are used. This is of course similar to many realms of the investment world.

Exotic countries like Peru, unusual commodity holdings like nickel or swing for the fence levered ETFs can be used such that the provide a little extra at the margin or cause a massive move in either direction.

Personally I don't think there is anything wrong with eating a doughnut every now and then--ie moderation. If you eat two for breakfast everyday and wash your lunch down with a soda or two then you probably not where you need to be health wise.

If you have 20% in various emerging market funds, 15% in various commodity products and 10% in a double long fund you probably are not where you need to be portfolio wise. The kick that those can give when markets are generally going up can be fantastic, the pain they could cause on the way down could be panic inducing.

It seems that no matter what happens people will always be risk junkies and it seems they are willing to take that risk at a bad time. Start with the idea that the average return for the broad market in a given year is close to 10%. If your return ranges from 8-12% and you save properly your probably going to be ok. So in that context, if you put 3% in the Peru ETF in a year that it doubles you are getting 300 out of the 1000 basis points you need for the year. If you also factor in getting 250 basis points in dividend yield for the year then you are more than halfway to what you need for the year and the rest of the portfolio doesn't have to work as hard, meaning you don't need as much volatility in the rest of the portfolio.

Practically speaking it is tough for a country fund to go up that much compared to a stock. One of the reasons I like to use more individual stocks than ETFs is that if you own 30 stocks and some ETFs to build a portfolio the chances are good that one stock will double or come close to doubling. It seems that during the bull market there were plenty of stocks that did this and that will likely be the case in the next bull cycle as well. This is not a brag about stock picking ability, I think if you look at the holdings in any mediocre mutual fund you will find a couple of stocks that have gone up 50-100%.

I would also add that very few stocks go to zero during bull markets. If you buy a stock and every other stock in the group goes up 20% the one you chose drops 25% you probably need to reassess the story. And if you did get one wrong, by having a moderate weight you don't blow up your portfolio.

Buying the iPath Tin ETN (JJT) a year ago at $51 only to have it cut in half on you in six months is not the worst thing you can do and may not even be that detrimental. Putting 10% in into JJT and it then cutting in half could have been a problem though. I mention JJT because I remember reading something very bullish and even more compelling about Tin about a year ago. I had all I needed in the way of commodity exposure, which is to say very little, but it was a good story.

The key to all these exciting investment themes and tasty doughnuts is moderation. An occasional doughnut for someone who is generally fit will not kill them. A small exposure to country that blows up will not kill a portfolio.