Bear Proofing Your Portfolio
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If you're like most investors, you're probably nervous about where the stock market is headed.
Here are some strategies to consider for preserving the value of your portfolio--no matter what happens to the market during the coming months. By taking action now, you will be able to relax, no matter what happens.
- Sell half your position in stocks that have had big gains this year. This is one way to have your cake and eat it.
Example: Last year, you bought 1,000 shares of a company at 10 pesos a share. Now the stock's price is 50 pesos. Even if you believe, for sound reasons, that the stock could go higher, you could protect your profits by selling 500 shares. That way, you would pocket 20,000 pesos in gains (before commission and taxes) and still profit from the company's future growth.
- Set stop-loss orders to protect yourself in case a stock fails to perform as you had hoped. Stop-loss orders authorize our stockbroker to automatically sell a stock once it reaches a price determined by you. This does not mean it will be sold at your price but at the available market price.
Example: Let's say you buy 1,000 shares of a company at 10 pesos a share on the expectation that its earnings will grow at 20% a year. But the company suddenly encounters supply problems and those expectations are dashed. Subsequently, the stock drops to 7 pesos a share while you're away on a trip.
Had you placed a stop-loss order to sell your stake at $9 a share, your position might have been liquidated before the stock lost another two points.
A good rule of thumb is to sell automatically when a stock drops 20% below its highest price since you owned it.
- When buying stocks now, only invest if there is little downside risk. Don't be dazzled by the prospect of big gains--without considering the possibility of big losses.
I hold onto a stock if it has the potential to increase its value by at least one-third over the next 12 months. But I won't buy a promising stock unless I also think its downside potential--its negative risk for investors--is half that amount. To put it another way, I look for a risk/reward ratio of at least two to one.
Example: If we think a stock is likely to go up by 40% over the next year, it might be a potential purchase as long as we think that it is unlikely to lose more than 20% of its value over the same period.
- When in doubt, hold onto the stock. The best approach to investing in stocks is to take a long-term view and to measure the success of your portfolio's performance over the next five to 10 years, not the next quarter.
This strategy allows you to filter out the temporary surges and dips in stock prices and focus instead on what hopefully will be the steady increase in their market value.
For this reason, there's something to be said for the advice of some successful older investors who say their secret was to buy stocks decades ago and stick them in a box. This strategy prevented the investors from selling when things got shaky or overheated. And because their stocks were generating dividends for them year after year, these investors got maximum mileage out of the enormous power of compounding--or the phenomenon of earnings producing more earnings.
- Diversify by buying bonds. Bonds generate a flow of income, which can be reinvested in stocks when a buying opportunity arises. There's no magic number for allocating a percentage of your portfolio to bonds or bond funds. Buy as much as you need to feel comfortable.
Adapted from: Bottom Line Year Book 1997, based on Douglas Raborn, chairman of Raborn & Co., a portfolio-management firm for individuals and retirement plans.« Read Previous Article Read Next Article »