Great Investment Vehicles

The proliferation of index-based products has provided us with great investment vehicles offering instant diversification. Some excellent examples are the S&P 500 SPDRs, the Dow Diamonds (DIA), and the Nasdaq 100 Trust (QQQ). However, a word to the wise: the diversification in these index-based products can be misleading. The Nasdaq 100 Trust comprises 100 stocks, so you might think you are receiving the diversification of 100 issues.

That�s not the case. The Nasdaq 100 is a capitalization-weighted index, and therefore, some stocks are more important in calculating the index than others. In fact, as we are writing this, the top ten stocks in the QQQ account for 43.487 percent of the movement of the Nasdaq 100, and the top twenty stocks account for 60.221 percent of the movement in the Nasdaq 100. That means when you purchase the QQQs you are essentially purchasing a basket of ten to twenty stocks, not 100 stocks. Purchasing a basket of ten technology stocks is a great way to play the technology movement, but you must be aware of exactly what you are purchasing so that you can accurately evaluate the position.

To illustrate the point, let�s look at the OTC Bullish Percent and the QQQs. The OTC Bullish Percent is an equally weighted index, since each stock gets one vote. It doesn�t matter that some stocks have a bigger capitalization weighting. Each stock gets treated the same. However, in the QQQ, the bigger the company, the more votes it gets. So if you try to trade the Nasdaq 100 based on the OTC Bullish Percent, your results may or may not be successful. Using the OTC Bullish Percent to trade the QQQs is like comparing apples to oranges.

A much better way to evaluate it is to examine very closely the top ten stocks comprising the index. These are the primary stocks that influence the price movement, so their performance will dictate the performance of the index. For instance, if the OTC Bullish Percent drops to 20 percent, but the top twenty- five capitalized stocks in the OTC market remain unchanged in price, then the QQQs would barely budge on the downside.

Remember, an OTC Bullish Percent reading of 16 percent would mean 16 percent of the stocks remained on buy signals. A better way to evaluate the QQQ is to look at a technical picture of the top ten capitalized stocks in the index. Let�s look at another example showing why it is important to evaluate what is moving these indices. Microsoft accounts for about 7 percent of the Nasdaq 100 Trust index. So let�s say you were thinking about buying the QQQ and also taking a big position in Microsoft. After realizing that Microsoft has a big influence on the index, you might decide to diversify with other software stocks.

In fact, did you know that when you look at the Nasdaq Composite, Dow Jones, and S&P 500, there are essentially thirty-one stocks that move 50 percent of each of these indices? Therefore, when you hear the popular financial news media talk about the market being up or down, keep in mind that they are talking about just thirty-one stocks! A great Web site for more information on many of these products is the Stock Exchange at www.5minutetrader.com.

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