If you're going to manage your own investments, it is crucial to ensure that no one disaster results in utterly catastrophic losses. The goal is to protect yourself -- not only from outright frauds such as Enron, WorldCom, and Global Crossing -- but from the legitimate firms whose shares got shellacked.

Think about the plummet we saw in Amazon ( AMZN), Yahoo ( YHOO), EMC ( EMC) and Sun Microsystems ( SUNW) after the tech bubble burst; the full list is way too long to detail here.

In my opinion, managing risk and limiting losses are the most consequential -- and underappreciated -- aspect of investing. Loss limitation has a much greater impact on portfolio performance than either stock selection or market timing. How you manage the risk in your holdings will have a more profound bearing on financial success than your stock selection.

It's a shame the subject is not "sexy" enough to warrant greater attention in the financial media.

Capital Lost

Enron currently stands as the U.S.'s largest corporate bankruptcy in terms of lost value -- about $66 billion. But don't think it takes a combination of fraud, deregulation and complicity from the bean counters for disasters of this magnitude to strike equity holders.

In terms of lost investor wealth, Enron actually compares favorably to other flameouts. EMC, Cisco Systems ( CSCO) and General Electric ( GE) each "lost" over $100 billion in market cap from December 2000 to their 2002 lows. From the perspective of market-cap loss, Lucent ( LU) shareholders would also have been collectively better off owning Enron instead.

Even (once) mighty Microsoft ( MSFT) -- with a market capitalization of $266 billion as of Thursday's close -- has suffered enormous losses. From its split-adjust peak of $60, to its post-bubble low near $20, more than $300 billion in Microsoft shareholder valued has disappeared.

So compared with any of these market crash calamities, Enron loss is relatively minor. That is truly astounding.

And it's not just the tech sector where shareholder losses accrue: From December 2000 to the present day, pharmaceutical giant Merck ( MRK) has dropped $120 billion in value. Even oil colossus Exxon Mobil ( XOM) lost over $105 billion of market cap from November 2000 to July 2002, before rallying in conjunction with rising oil prices.

What Moves Stocks?

In order to limit the havoc "disaster stocks" can wreak, it helps to understand what moves share prices.

Investors typically look to a variety of short-term factors. Ask most people why their stocks are going up and down, and they'll reel off a list of news-driven events: economic releases, analyst rating changes, quarterly earnings reports, conference calls, etc.

These factors have a de minimus impact when compared to the real action. The true cause is much less complicated: Share prices are moved by large-scale buying and selling by institutions. We discussed this extensively in Tracking the Elephants.

This relates directly to Enron's stunning decline from over $90 to zero.

From peak to pennies
Click here for larger image.
Source: Barry Ritholtz

Enron's stock gave many signals that it was under "distribution" by large shareholders. You may not have read about it in the paper, but Enron's chart told astute observers that big institutions were quietly unloading millions upon millions of shares.

A Fool & His Money

Using a modest stop-loss strategy, you could have bought Enron at its peak and limited your losses dramatically. Here's an example of how even an outrageous calamity like Enron need not be a total nightmare to a well-prepared investor:

Let's say someone was foolish enough to rely upon the sell-side analysts' "strong buys" on Enron in 2000. Our hypothetical investor -- let's call him Kenny Boy -- got suckered into Enron at the worst possible time, buying 1000 shares at its peak price of $90.

When he bought the stock, Kenny employed the very simplest loss limitation -- a straight 15% stop loss. He placed a "good till canceled" 15% stop loss order at $76.50. (Next week we'll go over a variety of stop-loss techniques.)

Towards the end of the year, Enron had broken $80 and was sliding further south. By mid-December 2000, the stock was flirting with Kenny Boy's stop point. Soon after, Kenny Boy was "stopped out" of Enron at $76.50.

Still, Kenny Boy's a sucker. He read a few positive articles on the company with titles like Enron's Power Play that got him excited again. As the broader market bottomed in April 2001, Enron appeared to stabilize. Just as Enron rallied to $60, poor Kenny Boy went back for more punishment. He bought another 1000 shares, with the same 15% stop in place.

A month later, the stop loss took Kenny Boy out again. This time, he was sold out of at $51, for a $9,000 loss.

Meanwhile, as the stock price slid, institutions may have been forced to dump shares in order to stay true to their investment style. For example, a large-cap growth fund, by its own charter, may not be allowed to hold mid-cap stocks. As a widely owned issue like Enron cratered, it created a self-fulfilling "death spiral."

As this was happening, our hypothetical investor remained a true glutton for punishment. During the post-9/11 swoon, Kenny Boy "caught the falling knife," once again picking up 1000 shares of Enron at $30. At least Kenny Boy was disciplined; he again relied on the 15% stop loss.

By the fourth quarter of 2001, stories were regularly appearing in the media about Enron's accounting issues. One day in October, after a particularly troublesome article, the stock "gapped down" at the open. Kenny's stop loss kicked in -- but not at $25.50 (15% below $30) as hoped for. Kenny Boy used a market -- as opposed to a limit -- stop-loss order. When the stock hit his number, his stop sell became a market order. The stock never traded at his number but "gapped down" to the lower price.

The gap down made poor Kenny Boy's execution awful; he was stopped out (for the third time), at $22.50 for a 25% loss.

Before we total Kenny Boy's losses, please note that he had the worst possible timing and execution possible. He bought at the top, got stopped out all three times, and even had a gap down which made his final sell much worse than expected.

Total damages: $30,000, or 33% of Kenny Boy's initial capital. That sounds pretty awful -- until you compare it with those people who did not have a stop loss plan in effect. These so-called long-term holders (also known as "deer in the headlights"), lost 99.89% of their capital. Their $90,000 initial purchase is now worth $110!

But unlucky Kenny Boy -- with a disciplined stop loss plan in effect -- still had $60,000 of capital left. The "buy and hold" crowd losses were 100% while Kenny Boy's were 30%. That's a huge difference.


Enron stands as important lesson in risk management and loss limitations. Jumbo losers can occur in any publicly traded company. Even "safe stocks" such as Exxon Mobil, GE and Microsoft are not exempt. Equities are volatile, and require a well thought out risk-management plan.

The key to avoiding catastrophic losses in any stock is in recognizing when institutions are dumping their shares and getting out of their way. As we have noted before, investors who fail to learn this lesson get trampled by elephants.

Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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