Protecting Your Stock Portfolio

A sobering fact is that a stock can go bad and you can irretrievably lose all or most of your money.

Even when you practice due diligence, a stock can unexpectedly turn to the downside and become a disaster very quickly. Before you know what happens, the price plunges and the stock's value evaporates. If the loss represents a small percentage of your portfolio's value, you can reasonably expect that the future price appreciation of the remaining stocks will eventually offset the loss. But if the loss is a large percentage of the portfolio, you may have to add new money or wait a very long time for the portfolio to recover. If you're at a stage in your life where neither option is possible, you may suffer adverse financial and personal consequences.

We know real losses will occur so how can you manage your portfolio to guard against a catastrophe? Here I introduce the concept of the maximum acceptable loss, which is the amount of money that you could lose that would not alter your current or future life style. For example, assume you had a portfolio of stocks valued at $200,000 and a stock worth $4,000 went bankrupt so you lost that amount. Obviously, you would not be happy but because the 2% loss is within the day-to-day fluctuation of the portfolio's value, the loss is not significant. However, a $40,000 real loss in one stock is probably significant.

How do you set the maximum acceptable loss? That's strictly up to you. You're the only person who can quantify your loss tolerance. If you are starting a portfolio, you should determine your maximum acceptable loss before you start picking stocks. Once you have a portfolio, you should periodically review it and make adjustments accordingly. You may change the maximum acceptable loss amount as your portfolio changes in value or your financial circumstances change. For example, as the portfolio grows in total value, you could raise the maximum acceptable loss. Or if a stock's value exceeds the maximum acceptable loss, you could sell some shares of the stock to bring its value nearer the maximum acceptable loss. Then you could leave the proceeds in cash, buy more shares of another stock in the portfolio or buy a new stock.

Over time you could add more stocks to the portfolio thus lessening the overall impact of a single stock should it implode.