Want $1 million? Protect your portfolio

  @Money July 30, 2013: 12:20 PM ET
How to make a million dollars
(Money Magazine)

In this How to Reach $1 Million special report, you'll see how following five cardinal rules of business management can pay off for you personally. You'll discover how a sensible, businesslike approach to your personal finances can speed up the time it takes to get you into the millionaires' club.

This story explains how cutting your losses can take you to millionaire status.

Make more by losing less
MONEY screened for stock funds that lost at least 20% less than their peers in down months. Many far outpaced the broad market since 2000.
If you invested $250,000 in 2000, you'd have:
Yacktman (YACKX) $1,211,650
Nicholas Equity Income (NSEIX) $752,500
Parnassus Equity Income (PRBLX) $710,200
Vanguard Dividend Growth (VDIGX) $498,600
Standard & Poor's 500 $356,800
Sources: Bloomberg, Morningstar

Amid the financial crisis, businesses jettisoned money-losing units by the droves. That not only conserved cash but helped companies rebound more quickly once the economy picked up, since they were no longer weighed down by those losses.

Take Ford. Just two years after the automaker sold off its troubled Jaguar and Land Rover lines, for $2.3 billion in 2008, the company roared back to profitability.

Figuring out how to deal with your money-losing investments can go a long way toward improving your personal finances too. You just have to establish some ground rules.

Have an exit strategy

Establish limits for how much you're willing to lose. When the bear market began in October 2007, the managers of the Sierra Core Retirement Fund (SIRIX) immediately got to selling. They had no choice.

The fund's rules require selling certain types of holdings once they drop, in some cases if they fall as little as 4%. By early 2008, Sierra had dumped most of its equities and thus lost just 3% that year as the broad market sank 37%.

Related: Best deals in investing

"The path to a good night's sleep is strong discipline with a consistent exit strategy," says co-manager Frank Barbera Jr.

Okay, when should you start selling? Mike Scarborough, president of Scarborough Capital Management, suggests setting a trigger based on your age and type of stock.

While a 55-year-old might want to sell a blue-chip stock or an actively managed fund once losses exceed 10%, a fortysomething can hang on until 15%, he says. With more volatile, small-company stocks and funds, he suggests a 15% threshold for older investors and 20% for younger ones.

Related: 'How I made $1 million'

Remember, he's talking about selling an individual security here, not abandoning your equity allocation. His point is simply that once a stock suffers steep losses, you're better off trying to make up that lost ground with a more diversified approach.

The math is powerful: If you can keep your aggregate losses to 10%, you'd have to regain only 11% to fully recover. Lose 40%, though, and you'd have to earn 67% to get back. That would take years.

For instance, assume that in 2008 you had $750,000 in your stock portfolio. That would have fallen to $472,500 after the crash. Even after a 4½ year bull run, you'd still be about $80,000 shy of the $1 million mark. Had you simply trimmed your 2008 losses by five points, though, your stocks would be worth $1 million today.

Seek downside protection

Go with funds that can weather storms. MONEY asked Morningstar for a list of no-load stock funds with below-average expense ratios and good track records that consistently outperformed in lousy markets.

Morningstar screened for U.S. portfolios based on something called "down-side capture." This gauges how well a fund performed in down months relative to its benchmark (go to Morningstar.com, type in a fund's ticker, and then hit the Ratings & Risk tab).

Several blue-chip stock funds have lost at least 20% less on average in recent downturns. Among them: Yacktman (YACKX), Nicholas Equity Income (NSEIX), and Parnassus Equity Income (PRBLX). Not surprisingly, had you invested in these funds at the start of 2000, you'd be on a much faster track to millionaire status.

Related: Emerging markets lose a step

Correct past mistakes, don't prolong them

You can't bank on a new housing boom. Homeowners who bought too much house in the bubbly 2000s have been struggling to stay afloat. This is particularly true for those who couldn't refinance recently because their mortgages were underwater.

Now that housing is back, though, should you take the opportunity to sell, or hold on in case prices snap back? If you've been sinking under a loan that's only now coming back to par, it's probably time to sell and downsize, says Seattle financial planner Karen Ramsey.

Housing is unlikely to revert to 2002-06 form. Moreover, homes have delivered annualized after-inflation price gains of 1.3% since 1900, vs. 5.4% for stocks, according to Credit Suisse Research. So your house is hardly the fastest way to $1 million.

Don't act like a shortsighted CEO by...

...dumping everything in your portfolio. According to Morningstar, U.S. stock funds with turnover rates of more than 200% (meaning they replace all their holdings at least twice a year) gained 7.2% a year for the past decade, vs. 9.2% for funds with less than 50% turnover.

Assuming you have $250,000, it would take you 20 years to hit $1 million at that slower pace -- four years longer than if you chose more patient fund managers.

More from How to reach $1 million:

Save your way to $1 million
Invest your way to $1 million
Become a millionaire by seeking growth
Become a millionaire by thinking differently
'How I made $1 million' To top of page

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