No Rally Can Help These Stocks

As stocks have moved upward over the past couple of months, many investors have started getting back into the bull-market mindset of trying to figure out how to maximize their returns without regard to risk. But for many investors, the losses they've suffered have been so bad that there's almost no possibility they'll ever earn back what they've lost.

In contrast, playing defense looks stupid during a bull market. But if you pay more attention to protecting your portfolio during tough times than you do worrying about milking every last percentage point out of a bull run, you'll stand a much better chance of turning your savings into significant wealth over the long haul.

It's simple math
At first, that statement seems counterintuitive. After all, how can you make money by sitting on the sidelines? Given how little cash investments like CDs are paying these days, you're not getting much reward for being out of stocks -- and you run the risk of missing a huge rally, exactly like the one we've seen since March.

When you take a closer look, though, you realize that even extraordinarily high returns during a rally don't amount to anything compared to the losses from making mistakes in bear markets. For instance, even though the stocks below have done extremely well since the March lows, they haven't come close to the gains they'd need just to get back to their 2008 levels:

Source: Yahoo! Finance.

Obviously, if you managed to steer clear of these stocks until they hit their lows, then the multi-bagger results you've earned must feel good. But for long-term shareholders, those huge gains are only a drop in the bucket compared to what they'll need to earn just to break even since mid-2008. This rally would have to go on for an awfully long time just to put them back in the black.

The lesson here is that if you suffer the kinds of huge losses that these stocks have seen in the past year, you've dug yourself into a hole you'll be lucky to ever escape from. From that perspective, it becomes much more important to minimize your losses -- even if it means giving up some returns during bull markets.

How to cut your losses
So, what can you do to protect yourself from crippling downdrafts in stocks? You have several options.

First, adding bond exposure to your portfolio can play a vital role in avoiding huge losses even in big bear markets like we've seen in 2008 and 2009. Although the S&P 500 lost 37% during 2008, a portfolio allocated half in S&P 500 stocks and half in a long-term Treasury bond ETF lost less than 2% last year. And while that balanced portfolio is down a lot more than the S&P so far in 2009, the combined returns since the beginning of last year still put a 100% stock portfolio to shame.

In addition, other asset classes -- along with some strategic thinking -- have helped professional investors earn amazing long-term returns. In this month's issue of Rule Your Retirement, Foolish retirement expert Robert Brokamp speaks with Mebane Faber, co-author of The Ivy Portfolio, about foreign stocks, commodities, real estate, and other investments you may not know as much about as you'd like. Moreover, the interview looks at more active steps you can take to protect your portfolio -- including developing a strategy to reduce market exposure at times of maximum risk.

No matter what you do, don't let outsized short-term gains in beaten-down stocks make you forget that avoiding big losses is essential to your long-term success. While bull markets make investors forget about the bad times, real wealth comes from those who manage never to lose huge amounts of money in the first place.

For more ways to get your portfolio out of the dirt, read about:

• Is it time for you to cash out of stocks?
• Be careful -- TIPS could be trouble.
• This is how you can wind up wealthy.