Protecting Your Portfolio from Extreme Events

Extreme events do not occur regularly within a market, but when they do occur they cause great destruction to unprepared investors. For example, a sudden market crash such as the one that occurred in 2007 cost millions of investors their life savings. While some risk is inherent in the market, it is important to guard your portfolio by using techniques to both anticipate losses and prevent them.

Educate Yourself

If you are not an investment professional, you may think it is impossible to anticipate the losses you could face in a market catastrophe. You will not have sophisticated knowledge of the market trends. However, this does not make you free from all responsibility. Even without sophisticated knowledge, you can work to cultivate a basic understanding of the factors at play in order to see market trends. Make a plan to educate yourself on the market:

  • Learn common investment terms
  • Read all information that comes your way about your investments such as financial statements and look books
  • Ask questions when you do not understand
  • Make a point of following changes in the market such as interest rate adjustments and inflation
  • Stick to what you know, and learn about any investment opportunity before deciding to jump into it

Mitigating Losses in Extreme Events

Even well educated investors looking for red flags can be blindsided when a true catastrophe strikes. This is where wise investors will have fail safe measures in place to mitigate losses. Consider the following options:

  • Stop order: You can issue a stop order to your broker on nearly any security. This order will tell your broker to sell or buy when the price of the share hits a certain level. If you place a stop order on the shares in your portfolio, you can make sure your broker "dumps" the shares in the case of a market crash. For example, if your $300 worth of shares in Company A fall to $200, your stop order may kick in, and your broker will sell. This prevents you from experiencing the even greater loss that would have occurred if the stock continued to tank.
  • Limit order: Stop orders are very effective when combined with limit orders. Since a stop order does not take place immediately, it is possible that the actual price you sell your shares for will be lower than the price you issued the stop order for. In a very volatile market, this is common. An extreme event causes a very volatile market. Even if you meant to sell your shares when they reached a certain price, your broker may not have been able to find a buyer until they had dropped another 50 percent. At that point, you wish you had simply hung on to the shares since they would be likely to at least increase marginally once the extreme event passed. With a limit order, you can "limit" the bottom level price you will sell for. So, your broker can issue the sale once the shares reach your stop price, but if they continue to fall past your limit price, the transaction will not go through.
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