One Thing You Can Do to Protect Your Portfolio From Losses, Part III

Today’s strategy is about the third way an investor can reduce risk. (Read Part I and Part II to catch up on the first two, asset allocation and position sizing.)

This third strategy I’m talking about is an exit strategy.

The technical term for it is stop-loss. Don’t worry, it’s simple to understand.

It’s just a price that you will sell the stock if the stock drops to that price. For example, if you buy a stock at $30, you might set a 25% stop-loss. (25% is common among investors.)

That means you would sell it if the price dropped to $22.50.

(Important side note… I don’t recommend entering this with your broker. If you do, it’s there for the market makers to see. It’s like a football team giving the other team their playbook. They can use it against you. Write it down and use discipline to exit the trade when the price drops to your stop-loss price.)

Let’s take a closer look at the process…

Remember, stocks are part of an overall asset allocation strategy.

Within that stock allocation, you need to think about position sizing. For example, an investor could take 1-5% of their stock allocation and buy individual stocks.

Once you’ve thought about position sizing, it’s now time to think about an exit strategy and setting your stop-loss.

An exit strategy is like having another layer of protection on top of your position size. If you have a portfolio size of $100k, and you allocate 1% or $1k to individual stocks, a 25% stop-loss on the stocks limits your losses to $250. (.0025% or a quarter of 1% of your entire portfolio.)

One big reason for an exit strategy with individual stocks is because buying shares of stock is riskier than buying a fund that tracks the S&P 500 index.

It’s not just market risk you’re worried about. (Market risk is about the ups and downs of the general economy.)

With individual stocks, you need to deal with company and industry risk. There’s always the chance a company could go bankrupt. More so in boom and bust industries. (If the S&P 500 Index goes to zero, we’ll have bigger things to worry about!)

Junior gold mining stocks or other resource stocks are a good example.

The reason an investor might put a small percentage of their stock allocation to individual stocks is for the chance of big gains. A boom and bust industry like oil or gold mining could offer more upside potential than just a stock mutual fund or ETF that tracks the S&P 500 index.

For example, in a gold bull-market junior gold mining stocks could soar several hundred percent. In a bear-market, they could go to zero.

Stop-losses give you a third lever of control. Or another way to minimize risk.

They keep you from your biggest threat to successful investing… Yourself. Psychology and emotions do more damage than the ups and downs of the market do.

OK, let’s recap this three-part series and put it all together…

First, you have asset allocation. It’s responsible for 100% of total returns. An easy example to see this is in terms of four asset classes and a total portfolio of $100k.

An investor may decide to invest 25% of his money is in stocks, 25% in bonds, 25% in real estate and 25% in gold. In other words, $25k in each asset class.

OK, the next thing is position sizing. Let’s look at the 25% allocation to stocks. Position size is how much money you invest within the stock class.

You could put a percentage in a U.S. stock fund, a European stock fund, a small-cap fund, a value fund, a growth fund, individual stocks etc.

In this case, maybe that’s $12k in a U.S. stock fund, $12k in a European stock fund and $1k to buy individual stocks.

Lastly, is what you learned today… An exit strategy and using a stop-loss to add a third layer of protection to your portfolio.

Using the example from above, you could take $1k (or 1% of your total portfolio size) and buy one individual stock.

You buy $1k worth of Fortune Maker Co. at $25 per share.

You set a 25% stop-loss. Which means if the stock drops to $18.75, you will sell it.

You’ve reduced your risk to only losing $250. Or only a quarter of 1% of your entire portfolio.

That’s it.

That’s your three-step process for protecting your portfolio from losses. The main goal at The Champion Investor is to preserve wealth so multiple generations of family can prosper.

The second goal is to build wealth.

You can do both of those by combining asset allocation, position sizing and exit strategies into your investment process.

Look at your portfolio and consider using these strategies. Your investing success depends on it.