The key to successful long-term investing is preserving capital. Warren Buffett, arguably the world's greatest investor, has one rule when investing - never lose money. This doesn't mean you should sell your investment holdings the moment they enter losing territory, but you should remain keenly aware of your portfolio and the losses you're willing to endure in an effort to increase your wealth.
While it's impossible to avoid risk entirely when investing in the markets, these six strategies can help protect your portfolio. In a market downturn, MPT disciples believe a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class , thus reducing unsystematic risk.
This is the risk that comes with investing in a particular company as opposed to systematic risk , which is the risk associated with investing in the markets generally. Stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk, according to some financial experts.
Unfortunately, systematic risk is always present. However, by adding non- correlating asset classes such as bonds, commodities, currencies and real estate to a group of stocks, the end-result is often lower volatility and reduced systematic risk due to the fact that non-correlating assets react differently to changes in the markets compared to stocks.
When one asset is down, another is up. Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns.
At least that's the theory. In recent years, however, evidence suggests that assets that were once non-correlating now mimic each other, thereby reducing the strategy's effectiveness. Why It's Still Hip. Investors generally protect upside gains by taking profits off the table. Sometimes this is a wise choice.
However, it's often the case that winning stocks are simply taking a rest before continuing higher. In this instance, you don't want to sell but you do want to lock-in some of your gains.
How does one do this? There are several methods available. The most common is to buy put options , which is a bet that the underlying stock will go down in price. Different from shorting stock, the put gives you the option to sell at a certain price at a specific point in the future. You're convinced that its future is excellent but that the stock has risen too quickly and likely will decline in value in the near term.
At this point, you sell the option for a profit to offset the decline in the stock price. Investors looking for longer-term protection can buy long-term equity anticipation securities LEAPS with terms as long as three years. Long-Term Equity Anticipation Securities: It's important to remember that you're not necessarily trying to make money off the options but are instead trying to ensure your unrealized profits don't become losses. Investors interested in protecting their entire portfolios instead of a particular stock can buy index LEAPS that work in the same manner.
Stop losses protect against falling share prices. Hard stops involve triggering the sale of a stock at a fixed price that doesn't change. A trailing stop is different in that it moves with the stock price and can be set in terms of dollars or percentages. What happens next determines which is more advantageous. Proponents of stop losses believe that they protect you from rapidly changing markets.
Opponents suggest that both hard and trailing stops make temporary losses permanent. It's for this reason that stops of any kind need to be well planned. Investing in dividend-paying stocks is probably the least known way to protect your portfolio. Historically, dividends account for a significant portion of a stock's total return. In some cases, it can represent the entire amount. Owning stable companies that pay dividends is a proven method for delivering above-average returns.
When markets are declining, the cushion dividends provide is important to risk-averse investors and usually results in lower volatility. In addition to the investment income , studies show that companies that pay generous dividends tend to grow earnings faster than those that don't. Faster growth often leads to higher share prices which, in turn, generates higher capital gains.
In addition to providing a cushion when stock prices are falling, dividends are a good hedge against inflation. By investing in blue chip companies that both pay dividends and possess pricing power , you provide your portfolio with protection that fixed income investments , with the exception of Treasury inflation-protected securities TIPS , can't match. Furthermore, if you invest in "dividend aristocrats", those companies that have been increasing dividends for 25 consecutive years, you can be virtually certain that these companies will up the yearly payout while bond payouts remain the same.
If you are nearing retirement, the last thing you need is a period of high inflation to destroy your purchasing power. For more insight, read Why Dividends Matter.
Investors who are worried about protecting their principal might want to consider principal-protected notes with equity participation rights. They are similar to bonds in that your principal is usually protected if you hold the investment until maturity. However, where they differ is the equity participation that exists alongside the guarantee of principal.
These notes will mature in five years. The issuer would buy zero coupon bonds that are maturing around the same time as the notes at a discount to face value. The bonds would pay no interest until maturity when they are redeemed at face value. The bonds would mature and, depending on the participation rate , profits would be distributed at maturity.
Risk-averse investors will find principal-protected notes attractive. Before jumping on board, however, it's important to determine the strength of the bank guaranteeing the principal, the underlying investment of the notes and the fees associated with buying them. Hedge Funds For Everyday Investors. Each of these strategies can help protect your portfolio from the inevitable volatility that exists when investing in stocks and bonds.
Choosing between them is depends on your individual financial situation. Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Non-Correlating Assets Stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk, according to some financial experts.
Stop Losses Stop losses protect against falling share prices. Dividends Investing in dividend-paying stocks is probably the least known way to protect your portfolio. Principal-Protected Investments Investors who are worried about protecting their principal might want to consider principal-protected notes with equity participation rights.
The Bottom Line Each of these strategies can help protect your portfolio from the inevitable volatility that exists when investing in stocks and bonds. How much a fixed asset is worth at the end of its lease, or at the end of its useful life. If you lease a car for three years, A target hash is a number that a hashed block header must be less than or equal to in order for a new block to be awarded.
Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage. The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as No thanks, I prefer not making money.
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