Never lose money. This is one of the most important rules that investors follow in their investing career. This of course doesn’t mean you shouldn’t let go of losing stocks.
What it means is that you should learn how to properly protect your portfolio from sudden market downturns.
In other words, preserving your capital is key to successful investing. Here are some of the most common and most effective portfolio strategies that you should know.
You’ve heard it before, and here it is again. Diversification is actually one of the cornerstones of the modern portfolio theory.
During a market downturn, MPT proponents argue that a properly diversified portfolio will outperform another that is not diversified.
To do this, investors need to create a portfolio that is broadly diversified. They simply own a large number of investments in more than one asset class. In the process, they decrease the unsystematic risk, which is a company specific risk.
Assets that Do Not Correlate
If there is unsystematic risk, there is also what we call the systematic risk, which is the risk that is generally associated with investing in the broader financial market.
There is no way you can diversify away systematic risk. However, you can at least reduce it. What you do is simply add non-correlating asset classes like bonds, commodities, currencies, and real estate to the stock that you hold in your portfolio.
These non-correlating assets usually react differently to the same market changes. They may even move inverse to each other.
That is, when one asset is going up, another asset is going down, and vice versa. As a result, non-correlating assets flatten out the peaks and valleys in your portfolio.
Stop orders or stop loss orders protect your trade against falling prices. Additionally, you can choose from a variety of stops.
For instance, hard stops get triggered and execute the sales of a stock at a fixed price that doesn’t change. That means if you buy a stock for $10, and the stop level you set is at $9, then the order executes the trade once the price falls below $9.
Another kind of a stop order is the trailing stop, which moves with the stock price. You can set this order using percentages or dollars.
For those who believe in stop orders, the functions let them protect their trades from the rapidly moving markets. However, opponents believe that such orders make temporary losses permanent.
So, before you use stop orders, you should carefully plan it.
This strategy is among the most popular and most effective way of protecting your portfolio. Dividends account for a huge chunk of a stock’s total return. Sometimes, it may even represent the entire amount.
To deliver above-average returns, investors try to own stable companies that pay dividends. Apart from the regular incomes, studies also suggest that companies that pay large dividends often end up growing faster than companies that do not pay dividends.
Faster growth usually means higher share prices. And higher share prices often generate large capital gains.