Managing your portfolio: First, do no harm

July 21, 2006

Investment Consult

Hippocrates knew the key to good patient care was to do no harm. The same philosophy applies to good portfolio management. If you invest in individual stocks, you know that you can't control a company's profits, or the movements of the market. The only thing you can control is your risk.

The key to preventive wealth care is to accept some small losses when necessary, but try to prevent major ones. Think about how much money you might lose on an investment before thinking about how much you could gain. Big losses are extremely hard to bounce back from. If a stock loses 50 percent of its value, for instance, it requires a 100 percent gain just to break even. But a loss of 10 percent requires only an 11 percent gain to get back to the price you paid.

If you have $100,000 to work with, initially invest only $10,000 in any one stock. If the company suddenly goes bankrupt, the maximum your portfolio will lose is 10 percent. If, on the other hand, you invest 50 percent of your capital in a single stock, half of your portfolio is at risk of being wiped out all at once. Usually stocks decline in price over several months before bankruptcy is declared; however, if you bought the stock at a low price thinking it was a bargain and then the company declares bankruptcy, you're in big trouble.

While you can't eliminate losses altogether, you can limit them by using a stop order, which you initiate with your broker and which instructs him to sell the stock if it falls by a predetermined amount.

Generally speaking, the amount you choose is that which you're willing to lose in order to take the chance that the stock can go higher in value. Use stop orders on all trades at all times; not using one is like going into surgery without a hemostat. Be sure to make the order "good till canceled" (GTC), so it remains in effect until you remove it or it gets triggered.

When setting a stop order, I suggest that your maximum "initial risk" on any trade should be 2 percent or less of your total portfolio. For instance, on a $100,000 portfolio you should limit your risk to a maximum of $2,000. If you buy 500 shares of a $20 stock, your stop order should be placed no lower than $16 ($20 – $16 = $4; $4 x 500 shares = $2,000).

Once a stock rises by an amount equal to your initial risk, move your stop order up to the price at which you bought the stock. Suppose you buy a stock at $20 and place your protective stop at $16. Once the stock reaches a price of $24, move the stop order to $20. If the stock price continues to rise, the breakeven stop becomes a "trailing" stop to lock in profits. And protecting your hard-earned profits is just as important as protecting your capital.

You can also reduce risk by buying stocks one at a time. When the protective stop level rises to breakeven on your first stock, then look for another investment opportunity. Buying in increments helps diversify your portfolio and limits risk to the maximum 2 percent (your initial risk).

Using the $100,000 we mentioned earlier, if one stock sinks and your protective stop order is triggered, your maximum loss will be limited to $2,000. However, if you buy five stocks at once (each risking 2 percent of your entire portfolio), you could lose 10 percent of your portfolio overnight from a huge market decline.