Financial disasters happen all the time -- occasionally to you! That's why you need to be prepared. You may be carrying enough insurance to offset the costs of any sudden natural disaster, and investing in a diversified portfolio has protected you at least in some part from losses and underperformance.

But there's probably one financial disaster you haven't anticipated: What if your stock holdings go through the roof?

The perils of portfolio pops
Imagine that you buy shares of Scruffy's Chicken Shack (Ticker: BGAWK) for $20 apiece. Within a year, thanks to some super earnings reports and bullish commentary from management and analysts, the stock tops $50. You've made more than 150% on the stock, which is good news. But here's the disaster:

  • You've made much more than you expected to on this holding, in a short time frame. You'd aimed to hang on for many years. Do you keep holding, or sell? You don't know what to do next.
  • Your portfolio is suddenly overweighted with this stock. Let's say that you originally invested $10,000 in each of 10 stocks. Suppose that in one year, nine of them averaged 10% gains, while Scruffy's grew by 150%. You'd end up with $11,000 in each of the other stocks and $25,000 in Scruffy's, increasing your initial $100,000 to $124,000. But Scruffy's would now represent 20% of your portfolio. Do you really want a full fifth of your holdings in this single stock?
  • Your emotions are battling each other. Fear is telling you to sell before the stock falls, while greed is telling you to hang on, so that it can gain another 150% or more.

For someone who's made $15,000 on one stock in a year, you're in quite a pickle, no?

This isn't such an extreme situation, either. Even in this tough market, getting in at the right time could have produced some big gains. Take a look at some of the following recent year-to-date returns:

Stock

YTD Return

Ford Motor (NYSE:F)

211%

Freeport McMoRan Copper & Gold (NYSE:FCX)

204%

AMD (NYSE:AMD)

172%

Goldman Sachs (NYSE:GS)

127%

Apple (NASDAQ:AAPL)

123%

Starbucks (NASDAQ:SBUX)

114%

Morgan Stanley (NYSE:MS)

104%

Source: Yahoo! Finance.

Your stock-surge scenario strategy
So what should you do in this situation? Well, I've been there myself, many times. I wrote about one such instance in my article "I Turned $3,000 Into $210,000," in which I detailed my investment in America Online, which later became part of Time Warner. With a cost basis of about $1 per share (in split-adjusted terms), I watched the stock surge to around $70, and I didn't sell. Then I watched it fall into the teens.

Here's my advice if you find yourself in a stock-surge situation:

  • Try not to think too much about the past. Focus on the future, and your estimate of the stock's intrinsic value. If the stock is at $50 now, and you think it's really worth $65, holding on might be smart, whether you bought your shares at $20 or $80. No matter where your entry point was, you're now at $50, expecting an eventual gain of around 30%. Look forward, not backward.
  • When any holding becomes too uncomfortably large, consider selling some shares to rebalance your portfolio. If, say, a quarter of your portfolio rests in a single holding, you might want to sell some shares. I can't give you any hard-and-fast guidelines, but listen to your gut and gauge your own confidence in each of your holdings.
  • Evaluate the holding regularly. Keep up with its progress. Assess its health. Is it growing briskly? Is debt under control? Are inventories growing no faster than sales? Does the company have some lasting competitive advantages? Do you trust management? Is the future bright?
  • When in doubt, sell. Or at least sell some. Especially if you realize that you really don't know all that much about the company, and how it makes its money. If that's the case, you've really just been lucky. If you can't decide whether to sell or hold, just compromise by selling one-third, or one-half, of your shares.

And remember not to complain: Given how much people have lost lately, you won't get any sympathy!

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This article was originally published on June 18, 2007. It has been updated by Dan Caplinger, who owns shares of Freeport-McMoRan and Starbucks. Apple and Starbucks are Motley Fool Stock Advisor picks. The Fool owns shares of Starbucks. Try any of our Foolish newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.