6 Common Portfolio Protection Strategies

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The Bottom Line Warren Buffett, arguably the world's greatest stock picker, has one rule when investing: Never lose money.

Determining Where to Set Your Stop-Loss

This doesn't mean you should sell your investment holdings the moment they start heading south. But you should remain keenly aware of their movements and the losses you're willing to endure.

While we all want our assets to be fruitful and multiply, the key how to make money hill successful long-term investing dhow theory in options preserving capital. While it's impossible to avoid risk entirely when investing in the markets, these six strategies can help protect your portfolio.

Preservation-of-capital techniques include diversifying holdings over different asset classes and choosing assets that are non-correlating that is, they move in inverse relation to each other. Put options and stop-loss orders can prevent stem the bleeding when the prices of your investments start to drop. Dividends buttress portfolios by increasing your overall return.

Principal-protected notes safeguard an investment in fixed-income vehicles. Diversification One of the cornerstones of modern portfolio theory MPT is diversification.

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Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset classthus reducing unsystematic risk.

Stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk, according to some financial experts.

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Non-Correlating Assets The opposite of unsystematic risk is systematic riskwhich is the risk associated with investing in the markets generally. Unfortunately, systematic risk is always present.

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However, there's a way to reduce it, by adding non- correlating asset classes such as bonds, commodities, currencies, and real estate to the equities in your portfolio. When one asset is down, another is up.

6 Common Portfolio Protection Strategies

So, they smooth out the volatility of your portfolio's worth overall. Dhow theory in options, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns.

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At least that's the theory. This strategy has become harder to implement In recent years. Following the financial crisis ofassets that were once non-correlating now tend to mimic each other and move in tandem response to the stock market. 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 optionswhich is a bet that the underlying stock will go down in price. You're convinced that its future is excellent but that the stock has risen too quickly and is 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. Investors interested in protecting their entire portfolios instead of a particular stock can buy index LEAPS that work in the same manner.

Stop Losses Stop loss orders protect against falling share prices. Hard stops involve triggering the sale of a stock at a fixed price that doesn't change.

Divine Command Theory

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.

Dividends 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.

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In some cases, it can represent the entire amount. Owning stable companies that pay dividends is a proven method for delivering above-average returns.

In addition to the investment incomestudies 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. So, how does this protect your portfolio? Basically, by increasing your overall return. When stock prices are falling, the cushion dividends provide is important to risk-averse investors and usually results in lower volatility. In addition to providing a cushion in a down market, dividends are a good hedge against inflation.

Dhow theory in options investing in blue-chip companies that both pay dividends and possess pricing poweryou provide your portfolio with protection that fixed-income investments —with the exception of Treasury inflation-protected securities TIPS —can't match.

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Principal-Protected Notes Investors who are worried about maintaining their principal might want to consider principal-protected notes with equity participation rights. However, where they differ is the equity participation that exists alongside the guarantee of principal.