Investment portfolios should contain a minimum of twenty stocks, with no single industry accounting for more than 15% of the total value at the time that the portfolio is constructed. Even with such diversification, a portfolio of stocks is vulnerable to the risk of at least a 60% loss from peak to trough (there have been several 50 - 60 % stock market declines in my lifetime, but feel free to pick any number between 60% and 99%, depending on how nervous you are about investing in stocks). I hope to avoid major market declines by pulling out when I correctly foresee a recession, but even successful economic forecasting does not protect against all bear markets. Some investment pros advocate limiting a portfolio's loss to say, 20%, at which point one liquidates and walks away. But this method is effective only if one never goes back into stocks. For example, a 20% trigger point would have produced a 20% loss in 2008. But if one re-entered the market in, say, January, 2009, one would have liquidated by March, 2009 with another 20 % loss. Indeed, one potentially could string together a whole series of 20% losses. All that does is spread the loss over a longer time period, without limiting the total loss. And during the periods between liquidation and re-entry the investor remains on the sidelines with no chance of recovery.
Another problem with liquidating upon some predetermined loss percentage is that it fails to protect against a rapid market meltdown. During the 1987 crash, stock prices dropped about 5% one day (a Friday), then another 23% the next day that the market opened. The total decline from the peak was about 1/3. If one's portfolio is already down by, say, 10%, another 23% decline in one day puts you well below a 20% loss threshold in a flash. Indeed in the 2007-2009 bear market, there were several days when the market opened 5% or more below the closing prices from the night before, so there was no chance to liquidate at points in between. In 1987, stocks rose to new highs by the end of the year. So any investors who liquidated after the crash and stayed away from stocks would have missed out on the recovery. Likewise, most who liquidated after the drop in early 2009 likely missed out on the recent 50% rise to new highs for the year. In both cases, liquidating to prevent further loses had the unwanted effect of making impossible the recovery of the investors’ assets.
Corporate and government bonds are also subject to considerations regarding risk. Corporate bonds are subject to the risk of default (like if one owned Lehman Bros. or Six Flags bonds). Both corporate and government bonds are subject to the risk that their value will decline if interest rates rise or bond ratings decline. The most serious risk of all, however, is that inflation will erode the purchasing power of the fixed interest payments each year and will decimate the purchasing power of the principal upon maturity.
The best risk management method is to place some assets into Treasury Inflation-Protected Securities (OTC:TIPS). These are U.S. Government bonds that pay a low rate of interest, but the interest payments and the principal are both guaranteed to increase with the rate of inflation. Both the interest received and the increased principal value that accrues each year are taxable income. In IRA and other tax-deferred accounts, tax is not payable until the money is withdrawn. These bonds can be purchased directly from the U.S. Treasury or through a bank or broker. Also, there are mutual funds that invest in TIPS and exchange traded funds (ETFs) that invest in TIPS.
Risk management in stock investing cannot be achieved simply by selling as stock prices decline. Nor can risk management be enhanced by sticking to stocks of safe companies. (Define “safe”: Citigroup (NYSE:C)? General Electric (NYSE:GE)? Fannie Mae (FNM)? Freddie Mac (FRE)? AIG Insurance Co. (NYSE:AIG)? Polaroid? General Motors (OTC:MTLQQ)?) The bottom line is that the best risk management program for stock investing is found outside the stock market: in the government securities market through the purchase of TIPS. For funds not needed over the next few years, the lowly stock market, after getting beaten up over the past decade, remains a good bet to resume its long-term (100 year) pattern of providing a 9.5 % rate of return. And, even after their recent run-up, stocks remain on sale at prices 1/3 below the highs of two years ago.
Disclosure: No positions in any of the companies mentioned in this article.