Warren Buffett, arguably the world's greatest stock picker, has one rule when investing: Never lose money.

This doesn't mean you should sell your investment holdings the moment they start heading south. But you should remain keenly aware of their movements and the losses you're willing to endure. While we all want our assets to be fruitful and multiply, the key to successful long-term investing is preserving capital. While it's impossible to avoid risk entirely when investing in the markets, these six strategies can help protect your portfolio.

key takeaways

  • The cardinal rule of investing is: Protect and preserve your principal.
  • Preservation-of-capital techniques include diversifying holdings over different asset classes and choosing assets that are non-correlating (that is, they move in inverse relation to each other).
  • Put options and stop-loss orders can prevent stem the bleeding when the prices of your investments start to drop.
  • Dividends buttress portfolios by increasing your overall return.
  • Principal-protected notes safeguard an investment in fixed-income vehicles.

1. Diversification

One of the cornerstones of modern portfolio theory (MPT) is diversification. In a market downturn, MPT disciples believe a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class, thus reducing unsystematic risk. This is the risk that comes with investing in a particular company. Stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk, according to some financial experts.

2. Non-Correlating Assets

The opposite of unsystematic risk is systematic risk, which is the risk associated with investing in the markets generally. Unfortunately, systematic risk is always present. However, there's a way to reduce it, by adding non-correlating asset classes such as bonds, commodities, currencies, and real estate to the equities in your portfolio. Non-correlating assets react differently to changes in the markets compared to stocks—often, they move in inverse ways, in fact. When one asset is down, another is up. So, they smooth out the volatility of your portfolio's worth overall.

Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns. At least that's the theory.

This strategy has become harder to implement In recent years. Following the financial crisis of 2008, assets that were once non-correlating now tend to mimic each other and move in tandem response to the stock market.

3. Put Options

Between 1926 and 2009, the S&P 500 declined 24 out of 84 years or more than 25% of the time. Investors generally protect upside gains by taking profits off the table. Sometimes this is a wise choice. However, it's often the case that winning stocks are simply taking a rest before continuing higher. In this instance, you don't want to sell but you do want to lock in some of your gains. How does one do this?

There are several methods available. The most common is to buy put options, which is a bet that the underlying stock will go down in price. Different from shorting the stock, the put gives you the option to sell at a certain price at a specific point in the future.

For example, let's assume you own 100 shares of Company A, which has risen by 80% in a single year and now trades at $100. You're convinced that its future is excellent but that the stock has risen too quickly and is likely will decline in value in the near term. To protect your profits, you buy one put option of Company A with an expiration date six months in the future at a strike price of $105, or slightly in the money. The cost to buy this option is $600 or $6 per share, which gives you the right to sell 100 shares of Company A at $105 sometime before its expiry in six months.

If the stock drops to $90, the cost to buy the put option will have risen significantly. At this point, you sell the option for a profit to offset the decline in the stock price. Investors looking for longer-term protection can buy long-term equity anticipation securities (LEAPS) with terms as long as three years.

It's important to remember that you're not necessarily trying to make money off the options but are instead trying to ensure your unrealized profits don't become losses. Investors interested in protecting their entire portfolios instead of a particular stock can buy index LEAPS that work in the same manner.

4. Stop Losses

Stop loss orders protect against falling share prices. There are several types of stops you may use. Hard stops involve triggering the sale of a stock at a fixed price that doesn't change. For example, when you buy Company A's stock for $10 per share with a hard stop of $9, the stock is automatically sold if the price drops to $9.

A trailing stop is different in that it moves with the stock price and can be set in terms of dollars or percentages. Using the previous example, let's suppose you set a trailing stop of 10%. If the stock appreciates by $2, the trailing stop will move from the original $9 to $10.80. If the stock then drops to $10.50, using a hard stop of $9, you will still own the stock. In the case of the trailing stop, your shares will be sold at $10.80. What happens next determines which is more advantageous. If the stock price then drops to $9 from $10.50, the trailing stop is the winner. However, if it moves up to $15, the hard stop is the better call.

Proponents of stop losses believe that they protect you from rapidly changing markets. Opponents suggest that both hard and trailing stops make temporary losses permanent. It's for this reason that stops of any kind need to be well-planned.

5. Dividends

Investing in dividend-paying stocks is probably the least known way to protect your portfolio. Historically, dividends account for a significant portion of a stock's total return. In some cases, it can represent the entire amount.

Owning stable companies that pay dividends is a proven method for delivering above-average returns. In addition to the investment income,
studies show that companies that pay generous dividends tend to grow earnings faster than those that don't. Faster growth often leads to higher share prices which, in turn, generates higher capital gains.

So, how does this protect your portfolio? Basically, by increasing your overall return. When stock prices are falling, the cushion dividends provide is important to risk-averse investors and usually results in lower volatility.

In addition to providing a cushion in a down market, dividends are a good hedge against inflation. By investing in blue-chip companies that both pay dividends and possess pricing power, you provide your portfolio with protection that fixed-income investments—with the exception of Treasury inflation-protected securities (TIPS)—can't match.

Furthermore, if you invest in "dividend aristocrats," those companies that have been increasing dividends for 25 consecutive years, you can be virtually certain that these companies will up the yearly payout while bond payouts remain the same. If you are nearing retirement, the last thing you need is a period of high inflation to destroy your purchasing power.

6. Principal-Protected Notes

Investors who are worried about maintaining their principal might want to consider principal-protected notes with equity participation rights. They are similar to bonds in that they are fixed-income securities that return your principal investment to you if held until maturity. However, where they differ is the equity participation that exists alongside the guarantee of principal.

For example, let's say you wanted to buy $1,000 in principal-protected notes tied to the S&P 500. These notes will mature in five years. The issuer would buy zero coupon bonds that are maturing around the same time as the notes at a discount to face value. The bonds would pay no interest until maturity when they are redeemed at face value. In this example, the $1,000 in zero-coupon bonds is purchased for $800, and the remaining $200 is invested in S&P 500 call options.

The bonds would mature and, depending on the participation rate, profits would be distributed at maturity. If the index gained 20% over this period and the participation rate is 90%, you would receive your original investment of $1,000 plus $180 in profits. You are forfeiting $20 in profits in return for the guarantee of your principal. But let's say the index loses 20% over the five years. You would still receive your original investment of $1,000; in contrast, a direct investment in the index would be down $200.

Risk-averse investors will find principal-protected notes attractive. Before jumping on board, however, it's important to determine the strength of the bank guaranteeing the principal, the underlying investment of the notes and the fees associated with buying them.

The Bottom Line

Each of these strategies can protect your portfolio from the inevitable volatility that exists in the investment world. Not all of them will suit you or your risk tolerance. But putting at least some of them in place may well help preserve your principal—and help you sleep better at night.