The Only Rule Investors Should Never Break

Estimated reading time: 6 minutes

There’s only one rule for investors – don’t panic sell as soon as the future looks bleak.

Always keep aware of how investments perform and set a limit for the loss you are willing to accept.

Although losses are inevitable, your ring-fenced capital should never be at risk if your portfolio is structured correctly.

If you plan to turn your investing up a gear, here are some professional strategies to protect your portfolio.

Protecting An Investment Portfolio

Protecting a portfolio is about preserving capital – the money an investor stakes, not the money an investment makes.

These techniques include diversification and picking assets that move in opposite directions to each other.

The aim is to have a portfolio comprising a broad range of assets.

Investors can also have a toolkit that includes options and stop orders that stop money from leaking from the portfolio.

Each tip protects a portfolio from volatility to varying levels, but deciding if they suit you depends on the risk you are ready to take.

Diversifying A Portfolio

Diversification is the investor’s main defence when markets turn south.

The theory is that a portfolio invested in several different asset classes is unlikely to see every investment lose value simultaneously. Technically, diversification is a tool for minimising risk.

Financial experts have differing views about how to diversify but generally accepting a portfolio with between 12 and 30 separate assets can do away with most, if not all, risk.

For example, an investment portfolio might include rental property, stocks from a property company and a property fund. However, this is not diversification because each investment will struggle if the property market tumbles.

What Are Correlating Assets?

Correlating assets are investments that move similarly despite not being in the same market.

Choose non-correlating investments, like bonds, commodities and currencies, to protect a portfolio. The idea is to pick assets other than equities because they move opposite to stocks and shares.

Other assets take up the slack if the stock market drops and generate gains. With non-correlating assets, when one price falls, another asset rises in value if the stock market drops, smoothing any losses.

The theory with non-correlating investments is eliminating boom or bust stems big losses, giving a balanced return.

Protecting Assets With Put Options

Investment values change all the time and not always in a positive way.

The Standard and Poor’s (S&P) 500 dropped in value in 24 of the 84 years between 1926 and 2009 – which is a one-in-four failure rate. Investors will try to protect their gains by selling stock, but this can be a mistake as many stocks ‘rest’ a while before they continue to rise.

A common way to deal with this situation is a put option.

A put option is a bet on whether a stock will fall in price. The option lets you sell at a pre-agreed price on a specific day.

For example, an investor owns 1000 shares in ABC Ltd, which have risen in value by 80 per cent in a year and trade at £100. The investor believes more gains will come, but that might mean a slight drop before the price takes off again.

To safeguard the position, the investor buys a put option on ABC Ltd with a strike price of £105, expiring in six months.

The put option costs £600 – £6 for each share. The option gives an investor the right to sell the shares for £105 each before expiration.

If the share price drops, the option may be sold to offset the loss. The aim is not to make money from selling the option but to protect gains by offsetting any money raised from selling the option against losses in share value.

Put options do not come with a default time limit, but the longer the expiration date, the more expensive the option costs.

Investors can consider a long-term equity anticipation security (LEAPS) instead of a put option. LEAPS perform the same job but can last for up to 39 months.

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Hard And Soft Stops

Stop-loss orders are another way to stem portfolio losses.

The orders come in several types, the most popular being hard stops and trailing stops.

Hard stops set the sale of a stock at a specific price. For example, if shares in ABC Ltd are bought at £100 a share with a hard stop of £90, a sale is automatic when the price hits £90.

Trailing stops track share price movements, changing by a percentage amount, like 10 per cent.

Don’t forget trailing stocks only move if the investment price rises, and different stops can show varied results.

Don’t Ignore Dividends

Another trick to protect a portfolio’s value is investing in stocks that pay dividends.

Remember, dividends can comprise a significant amount of a stock’s yield and are often forgotten or underestimated.

Owning shares that keep a stable value but pay good dividends is a tried and tested way to pick up above-average returns.

Sticking To Principal Protection Notes

For investors with a rock-bottom attitude to risk, principal-protected notes (PPN) offer a minimum return that is at least equal to the investment, also known as the principal, regardless of how the assets perform.

Breaking down the jargon, a PPN with a 100 per cent guarantee of invested capital will repay the initial amount invested on maturity.

Although fixed-income investments and bonds offer portfolio protection with little risk, the returns are modest. The opposite end of the spectrum are stocks and shares, which offer high returns at great risk. PPNs fall in the middle.

Also known as guaranteed linked notes, PPNs are structured products issued by a bank or finance house which can be based on a mix of underlying indices, funds and stocks.

Costs and returns depend on several variables – the multiplication factor, i.e. 100 per cent; the stock price at maturity and the strike price.

Portfolio Preservation FAQ

What is a strike price?

The strike price of an option is the fixed cost that allows an option holder to buy or sell the underlying asset. The deal proceeds at the strike price regardless of the real-time value of an asset.

A put option is termed out-of-the-money if the strike price is below the value of the underlying stock, in-the-money if the stock price is lower and at-the-money if the strike and market value are the same.

What makes an investment portfolio?

Typically, an investor has a portfolio if they have investments in the stocks and shares of several companies. Other investments, such as property, bonds, cryptocurrencies and commodities, can be held in a portfolio.

What is correlation?

In investment, correlation is when different assets rise or fall in price together. Non-correlating shares tend to move in opposite directions, so when one rises, the other falls. The goal is to smooth peaks and troughs by balancing assets that do not correlate.

What is the participation rate?

A participation rate is the return of a principal-protected note expressed as a percentage. For instance, a PPN with a 100 per cent participation rate returns a full, initial investment.

What is systematic risk?

Investment always incurs a level of risk – but how much is up to the investor.

Systematic risk is always there and is reflected in volatility across all markets.

Unsystematic risk is particular to a market, company or industry and is reduced by diversification.

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