When people think about the triumphs of legendary investors like Warren Buffett, John Templeton and Peter Lynch, they tend to focus on their biggest winners.
Each of these men invested in stocks that went up hundreds – and even thousands – of percent.
They also had plenty of losers, of course. That’s unavoidable in the investment game.
But the one thing they all had in common – indeed the one thing all successful investors have in common – is they avoided catastrophe.
Catastrophe is not when you have a significant loss. Even a security that goes to zero is a manageable development if it makes up a relatively small percentage of your net worth.
But if you suffer devastating portfolio-wide losses, it can be very difficult and – depending on how much time you have left – perhaps even impossible to bounce back.
That’s why The Oxford Club recommends that you adhere to four basic principles of portfolio management…
No. 1: Asset allocation.
This refers to how you spread your risk among different asset classes: large and small cap stocks, growth and value equities, foreign and domestic markets, as well as different types of bonds, including high-grade, high-yield and inflation-protected. Asset allocate so that the securities in your portfolio don’t rise and fall in tandem, increasing volatility and risk.
No. 2: Diversification.
Owning a number of different securities in each asset class protects you against bankruptcy or default in any individual issue. This is not merely a protective move, by the way. Diversification lowers your risk, yes. But it also increases your chances of owning a big winner.
No. 3: Trailing stops.
Running a stop behind each of your individual stock positions gives you unlimited upside potential with strictly limited downside risk. (A 25% trailing stop is a good rule of thumb.) This protects both your profits and your principal. That’s just smart risk management.
No. 4: Position sizing.
We recommend never investing more than 4% of your portfolio in any individual stock. If it makes a big run, it may well become a much larger part of your portfolio. And that’s fine, as long as you’re using a trailing stop to make sure the gain doesn’t slip through your fingers. But look at how position sizing also protects you. If you take the maximum loss (25%) in your maximum position size (4%), your portfolio is worth just 1% less. Not bad for a worst-case scenario.
People who have made risky bets on options, futures, penny stocks and crypto – or invest with massive leverage – are taking a far greater risk of significant losses.
However, those who avoid the four bedrock principles above face the possibility of eventual catastrophic losses. A bit of basic math explains why.
Let’s say you have a portfolio worth $100,000.
If it declines 25% – to $75,000 – you need to earn 33% from there to regain your $100,000. That’s not difficult with time.
If your portfolio declines 50% – to $50,000 – you need a 100% return to be made whole again. That generally takes a period of years for an entire portfolio.
If your portfolio declines 75% – to $25,000 – you need a 300% return to regain the $100,000 mark. That might take over a decade.
And if your portfolio declines 90% – to $10,000 – you need to earn 900% just for your portfolio to regain its former value.
Good luck with that. You’re going to need it.
In short, you never want to lose sight of the big picture. Catastrophic losses can sink your entire investment plan.
That’s something to remember when virtually every asset class is moving higher.
It won’t always be this way. And the time to take protective measures is now.