One cardinal rule in investing is that you should not lose money. That doesn’t mean you should not have any losing trades or that you should let go of your investment once it goes bad. It only means that you should be super away of their movements and how much you are risking for them. The following are the most common strategies you can use to protect your investment portfolio.
Diversification is one of the golden rules that you should follow when investing. It’s also one of the most important lesson in the modern portfolio theory.
During a market downturn, a portfolio that has been well-diversified will outperform a concentrated one. This means you will create a deeper and more broadly diversified portfolio by owning a huge number of investments in more than one asset class. In the process, you reduce the unsystematic risk.
Unsystematic risk refers to the company-specific risks when you invest in a stock. Portfolios that include 12 to 20 different stocks can eliminate most of the unsystematic risks.
Correlation of Assets
If there is unsystematic risk, there is also the systematic counterpart. The systematic risks are risks that have something to do with investing in the markets in general.
This type of risk is not diversifiable, so it’s always present.
You can reduce such risk by investing in assets that have very low correlations or non-correlating assets, which can be bonds, commodities, currencies, and real estate.
The assets’ movements aren’t tied to equities’ movements. Sometimes, they even move in opposite ways.
To protect their upside gains, investors usually take their profits off the table—they sell. There are many times when this is a smart choice.
However, there are also times when winning stocks take a reset or breather first before they continue higher. In that case, you don’t want to sell. Yet, you still want to lock in some of your gains.
The most common way to do that is to buy put options, which is a bet that the underlying stock will go down in price.
This is different from shorting a stock in that it gives you the choice (option) to sell at a certain price at a specific point in the future.
You also have to remember that you’re not actually trying to make money off of the options contract. Rather, you’re ensuring that you’re unlocked profits do not turn in to losses.
Stop Loss Orders
Stop loss orders serve as a protection against slipping stock prices. There are many types of stops that you may use.
Hard stops involve the execution of the sale of a stock once a fixed price is reached. For instance, if you bought a stock at $20 and you place the hard stop at $18, the sales of the stock will commence once the price reaches $18 or below.
Those that use stop loss orders believe that these are protections from the rapidly changing markets. Meanwhile, there are those that say both hard and trailing stops make temporary losses permanent.