When Kirk Kinder starts talking to investors about building portfolios, one of the first issues he raises is how risky stocks and bonds can be in volatile financial markets.

Such a tolerance for risk, says the Bel Air, Md.-based portfolio manager and adviser, can't be overemphasized—especially in current times.

"A lot of investors got burned in the Tech wreck of 2000-2002," said Kinder. "Now, with another bear market coming six years later, people are really starting to reconsider their asset allocation plans."

He doesn't consider that necessarily a bad move. "It's not a bad idea to review your asset allocation," said Kinder, who's president of Picket Fences Financial, which also has offices in Clearwater, Fla. "But a lot of people are turning way too conservative. It's a mistake to panic at this point based on what has happened in the past year or two."

The 38-year-old former Coast Guard officer likens creating portfolios to building a ship. "You can build a cruiser or you can build a cutter for speed," said Kinder. "It all depends on where you're trying to go and how fast you want to get there."

When you run into rough weather, he points out, trying to outrun the storm or change course drastically can lead to even worse damage. "Believe it or not, if you're out to sea, you actually want to head right into the storm," said Kinder. "We were always trained that if a hurricane comes, trying to outmaneuver it can make things much worse."

He uses mostly exchange-traded funds for his clients and works with all income levels of investors. He charges 0.50% for a standard portfolio; depending on portfolio size, that can go below 0.25%.

"But for many people with smaller portfolios, that's still going to be cost-prohibitive," said Kinder. "So we'll work with them on an hourly basis and give specific recommendations."

Options Strategies With ETFs

Kinder has broken his strategies into six different model portfolios. "There are several variations from those, depending on individual situations," he said. "But those six serve as our main guide."

Kinder likes to use options with ETFs for investors requiring high levels of current income. "It can help lower portfolio risk and generate additional income on the ETFs," he said. "But a lot of people are scared of options. For those that are comfortable with an options strategy, we've made it a permanent part of their portfolios."

For example, he's using options with the SPDR S&P 500 (NYSE: SPY) for some clients. Kinder notes that the ETF now is currently yielding around 3.5%. "We'll sell an option for one month out. That means we're going to collect premiums from the buyer of the option. But they've got the right to call the option and come back to us and essentially take back our shares of SPY at a predetermined price," said Kinder.

Typically, he usually sells options on SPY and other ETFs about 10% above their current prices. "If the market goes up, our clients will still experience a 10% gain in their holdings. Plus, they get the premium they receive, which on SPY is drawing about 1% in extra income right now," said Kinder.

By remaining short term with his options strategy, he notes, "in a sideways-moving market, you can generate considerable additional income each month."

Options With Commodities

Kinder says there's enough liquidity in almost every major asset class these days to implement such an options strategy. In fact, he's even done it with the PowerShares DB Commodity Index Tracking Fund (NYSE: DBC). "Commodities are always a portion of our portfolios and DBC is very heavy in oil, which has been flat lately. So options are a good way to draw some extra income off this holding in our portfolios," said Kinder.

Use of options helps him avoid the temptations of trying to time markets, says Kinder. "I'm very disciplined about sticking to long-term asset allocations and rebalancing," he said.

Such options strategies helped reduce losses by about 8 percentage points last year compared with nearly identical portfolios not using options, Kinder estimates.

"But another big help was sticking with a disciplined rebalancing plan," he added. "When oil went from $70 to $140 early in 2008, we rebalanced fairly aggressively. That really helped since oil prices went in the opposite direction later in the year."

Depending on tax implications and other portfolio requirements, Kinder likes to rebalance at least once a year. "But if an asset class moves 5% one way or another, that will trigger us to at least review the situation," said Kinder.

"So if we've got a 10% allocation to REITs, for example, and they drop to 5% of the overall portfolio, then we'll look at rebalancing."

Big On Diversifiers

Besides commodities, he also likes to use real estate as diversifiers. In particular, Kinder prefers the iShares Cohen & Steers Realty Majors (NYSE: ICF); the iShares Dow Jones U.S. Real Estate Index (NYSE: IYR); and the Vanguard REIT ETF (NYSE: VNQ).

In his most aggressive stock portfolios, Kinder is allocating 30% to international funds. "If I'm writing options, then we like to stick with iShares because of their higher volume levels," he said. Those are the iShares EAFE Index (NYSE: EFA) and the iShares MSCI Emerging Markets Index (NYSE: EEM).  

If he's not pursuing an options strategy, then Kinder will use the Vanguard Emerging Markets Stock ETF (NYSE: VWO). But he breaks up developed markets using the Vanguard European Stock ETF (NYSE: VGK) and the Vanguard European Stock ETF (NYSE: VGK).

"In the EAFE index, Europe and Asia get lumped together. But long-term return patterns show that if you'd invest your developed markets allocations equally between the two, you'd wind up with higher returns and less volatility," said Kinder.

In the U.S., he also goes with iShares when implementing an options strategy. Those include SPY and the iShares Russell 2000 Index (NYSEArca: IWM). "With options, we're not looking to tilt towards different styles," said Kinder. "We keep to the main indexes in large- and small-cap stocks and ETFs with the biggest volume levels."

For portfolios not selling options, he favors the Vanguard Total Stock Market ETF (NYSE: VTI) and the Vanguard Small Cap Value ETF (NYSE: VBR). "We believe in taking a total stock market approach with a slight tilt to small-cap value," said Kinder.

He adds 10% each to REITs and commodities. "You need enough allocated in those two areas to make a difference to the overall portfolio," said Kinder. "Commodities and REITs are terrific diversifiers."

On the bond side, he uses both ETFs and index mutual funds. Some 20% of that fixed-income allocation goes toward the iShares Barclays TIPS Bond Index (NYSE: TIP).

Another 20% goes into the SPDR Barclays Short-Term International Treasury Bond Index (NYSE: BWZ).

If a client has money in a taxable account that is designated for bonds, Kinder will use a Vanguard municipal bond fund. But if not, he likes to slant bond portfolios heavily toward the Vanguard Short-Term Bond ETF (NYSE: BSV).

"Studies from Fama and French show that investors don't get compensated for taking the extra risks of longer-term bonds. So we prefer BSV to even the iShares Lehman Aggregate Bond Index [NYSE: AGG]," he said.