Take steps to avoid your portfolio doing “a Valerie”

You could be forgiven for feeling a bit queasy about checking your portfolio right now, given the volatility of recent weeks (see page 6). But spare a thought for Patisserie Valerie's shareholders. The cake-shop chain took investors by surprise last week when trading in its shares was suspended. The group revealed a £20m hole in its accounts, swiftly followed by an emergency rights issue (see page 8). That has kept it afloat, but when the shares start trading again investors may be looking at paper losses of 80%-90% compared with the pre-scandal closing price.

It's a nightmare we all want to avoid. But how? There are many accounting red flags to monitor (my colleague Matthew Partridge highlights some in his story on short-selling on page 28). If you're going to invest your hard-earned cash in an individual stock, then you certainly can't skimp on research. Yet the truth is that there are no magic formulae or ratios that will protect you 100% from a Patisserie Valerie scenario. To err is human, and if you invest in individual stocks regularly, you may well one day find yourself holding a firm that through malice, bad luck or incompetence gives you a nasty surprise.

So as well as thinking about how to avoid such an event, you also need to think about how to stop it from cratering your portfolio. The only way to do that is to diversify don't put all your eggs in one basket. How many stocks do you need? Academics will give you a range of answers from somewhere near 30 to more than 100, depending on how diversified you want to be. But in practical terms, there is a limit to the number of stocks you can monitor effectively at any given time. US investor Warren Buffett once suggested imagining that you can only make 20 investments in a lifetime, and it's probably unrealistic to have a portfolio much larger than this at any one time. Make sure your picks are from different sectors (a portfolio with 20 miners is not diversified), so that an industry-specific malaise doesn't end up hammering your portfolio. And rebalance regularly take profits on the winners and invest in the losers. That way, an individual nightmare shouldn't have a disproportionate impact on your wealth.

You don't have to take an all or nothing approach. You could use trackers or investment trusts for your core portfolio, then invest part of the equity chunk of your portfolio in individual stocks. That way you can try your hand while only exposing a small chunk of your portfolio to individual stock risk. This still leaves the question: what to do with a stock like Patisserie Valerie? We look at that in the box below.

What should I do if I own shares in Patisserie Valerie?

The other big question raised by Patisserie Valerie is, of course, what do you do if you own its shares? Fund of funds manager Lee Freeman-Shor covered this subject well in his book The Art of Execution. Freeman-Shor looked at the performance of 45 respected money managers he worked with. He found that when faced with situations such as the Patisserie Valerie bombshell, the most successful investors did one of two things they either sold out, cutting their losses and moving on to the next opportunity, or they topped up their holdings.

This sounds contradictory or obvious they either sold up, or they bought more. But in fact, it cuts to the heart of the matter. When faced with a nasty shock like this, most investors would rather ignore it. They don't want to crystallise the loss they'd rather not think about it at all. So they leave the holding to fester, hoping against hope one day it'll get back to even, or something close to it (I know for a fact that I've had positions like this sitting in my broker account and I'm sure you have too).

This is the worst thing you can do. As Freeman-Shor notes, in cases where a share price falls by 40% or more, it almost never gets back to its previous high. So what do you do? First, you need to get clarity on the situation, and then you need to decide: based on what you now know about the stock as opposed to your original criteria, which are now irrelevant would you buy or sell? Can the stock be turned around? If so, what do you estimate its value to be now, and is it sufficiently higher than today's share price to justify buying it?

With Patisserie Valerie, the hope is there is still a healthy underlying business. The risk is that when the accounts are tidied up, it'll turn out that there is a more fundamental problem to fix. We don't have that clarity yet, so for now, I'd hang on. But when the situation becomes clear, take action and if you find you are reluctant to buy, take that as a cue to cut your losses.