01/25/2012 01:56 pm ET Updated Mar 26, 2012

How to Manage Risk of Stock Investments Today?

Several decades back, managing investment risk was straightforward by today's standards. A simple strategy of "don't put all your eggs into the same basket" worked well: invest into many stocks with different businesses, the thinking went, and reap the rewards of positive returns in all market conditions. The key underlying premises of "multiple baskets" investing were two-fold:
  1. Stocks of companies in different industries rarely moved in tandem; and
  2. Most stocks were expected to rise in the long term.

Today, neither of the two principles holds: Many companies and their stocks face an uncertain future, and lots of stocks sway together in response to positive -- and especially -- negative economic news. With globalization reshaping traditional business models, domestic stock-issuing firms are under increasing margin-reducing pressure from lean foreign competitors. More important, however, is the increased interdependency of stock price movements in response to global economic announcements: As stocks move together up and down, all the investment baskets rise and fall at the same time, defeating the diversification principle.

Behind the stock interdependency and the new lack of diversification opportunities is the proliferation of Exchange Traded Funds (ETFs). Many of these funds are securities, designed to proxy the composition of indexes such as the S&P 500. The objective of these funds is to offer investors an inexpensive platform for diversification -- instead of diversifying by buying individual components of the S&P 500, for example, an investor can buy a much cheaper share of the S&P 500 ETF (ticker SPY), and obtain the return profile of the S&P 500.

While offering less expensive risk-return profile to investors, the ETFs linked returns of constituent securities to the returns of the ETFs themselves. By the so-called Law of One Price, an ETF comprising a basket of securities should be worth as much as the sum of prices of all individual securities inside the basket. Any price deviations can and are swiftly traded away by professional teams of statistical arbitrageurs, trained to detect upon minute deviations in the price discrepancies of ETFs and the underlying individual stocks. As individual securities are bought and sold bring their prices in line with the prices of their respective ETFs, the securities prices move closer and closer together.

Beating the ETF-imposed dearth of diversification opportunities is difficult, but not impossible. One solution lies in the nature of ETFs: Most of them comprise the largest stocks. Researching and investing into smaller stocks that eluded ETF packaging ensures that these stocks are not arbitraged with index ETFs. As a result, these stocks' fundamentals play a larger and more important role in their pricing, producing returns less dependent on those of other securities, and allowing for greater diversification in investors' portfolios.