Prevent Huge Portfolio Losses

One key to success in trading and investing is to prevent huge portfolio losses.  If you lose 50% of your portfolio, for example, then you have to gain 100% just to get back to even.  Off the top of my head, I can think of three ways to limit huge portfolio losses:

1. Diversify

What this really means is to include uncorrelated assets in your portfolio.  “Uncorrelated” means prices tend not to move in sync.  For example, if one goes up, the other goes sideways or down.  Alternatively, if one goes way down then the other goes up, sideways, or down a little.

The danger of diversification is that in extreme circumstances correlation can go to 1, which means everything moves together.  You could be invested in markets that had historically been uncorrelated but when the crash hits, everything goes down.  We saw this in fall 2008 when gold, bonds, and the stock markets all fell precipitously for a while.

2. Position size to limit total exposure.

If you are only 10% invested then the most you could ever lose if that asset (e.g. stock) goes to zero is 10%.  The remaining 90% of your portfolio would be in cash.

3. Buy puts

Put options profit when their underlying markets fall.  Options were originally created to serve as insurance and this is exactly what long puts can do.

Other ways of achieving this goal are to short markets or to buy inverse ETFs.