Unfortunately, far too few investors actually have any. Indeed, whenever we hear of some hedge fund that blew up, you often hear a manager lament, "If only we had stuck to our discipline." The pre-nup is a way to ensure that you avoid that fate.

Third, and finally, you want a record (paper or computer) of what you were thinking before entering this investment. We're all too capable of rationalizing our actions after the fact. I've heard investors come up with every excuse in the world to hold a dying position rather than admit they were wrong and move on. The pre-nup helps to eliminate that counterproductive behavior.

The Terms

A good pre-nup should answer the simple question: What are grounds for divorce?

  • Performance (bad): There are three objectives in jettisoning a poorly performing stock.
  • First, a recognition that you may have been wrong. For whatever reason, the trade simply didn't work. Perhaps it was the timing, or merely a case of bad luck. By having a strategy to cut your losses, you can redeploy capital more productively.

    Second, avoiding the debacles -- the Enrons, Nortels ( NT) or Lucents ( LU) of the world that whither away to become single digits, or zeros. Avoiding these disasters with only minor losses goes a long way toward keeping your portfolio healthy.

    Third, a disaster stock can easily dominate an investor's psyche. If you become totally wrapped up in a bad trade, it interferes with your ability to do anything else productive. Think back to how many people didn't even bother opening their statements during the 2001-2003 period. That's how debilitating major losses can be -- and why avoiding them is so crucial.

    In the near future, we'll look into a few stop-loss strategies that will help you in preparing the pre-nup. The key is to have a written explanation of what will trigger a sell in advance.

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