Don't lose your shirt in a bear market

• No new trades.

Strategy Lab is MSN Money's stock-picking challenge. To learn more about the game -- and the contenders -- click here.

"Rule #1: Never lose money.
Rule #2: Never forget Rule #1."

-- Warren Buffet

Referring to the wisdom of the world's greatest investor seems to be a common theme in the Lab this week, so I wanted to highlight again some of the rules I have developed -- and borrowed -- from Warren Buffet's annual shareholder letters.

These simple rules might help to explain why my Strategy Lab portfolio looks so different from everyone else's.

The test of trouble

First, I want to highlight an important factor for anyone who invests heavily in mutual funds. In my opinion, true investment talent can be separated from luck only in a period of bear-market turbulence.

During the roaring '90s, it was easy for a fund manager to claim he or she was great at picking stocks because most portfolios had done well during the widespread bull rally.Many of these "hot" funds ceased to exist during the 2001-02 bear market.

A similar chain of events is unfolding today. Most of the former star "financial- sector heavy" mutual and hedge funds have suffered blows that have forced them to halt redemptions, or even to close outright. This pain could have been avoided.

A history of outperformance in rough markets should be one of the most important factors when deciding to invest in a mutual fund. Instead of relying purely on the Morningstar rating system, spend an extra few minutes studying the fund's performance during the last bear market. If you see heavy losses that were made up only in go-go bull times, run in the opposite direction.

There's no gain in losing money

As Buffett says, the first objective of any investment manager should be to make sure he or she does not lose clients' money, period. Swinging for the fences to achieve 40% returns could be a great strategy for winning an investment contest or for earning a quick bonus if you work in the most prestigious legalized gambling arena in the United States -- Wall Street. But it can quickly become a major pain for the unsuspecting retail investor.

I personally am an opinionated, active value investor who likes to disagree with the general public's opinion. I tend to trade in and out of my losing positions much faster than the typical Buffett admirer. The explanation for this difference, in my mind, is very simple. Even if we utilize all of the well-known Buffett valuation principles (focusing on free cash flow, low multiples, etc.), let's be realistic. We can't possibly emulate his strategy perfectly.

We simply don't have the virtually unlimited resources, the ability to interview any executive in the country or the ample liquidity to ride out any personal downturn. In addition, our time horizons are likely to be much shorter than Buffett's. He'll never have to sell a holding to fund a kid's tuition or pay for an unexpected medical emergency.

So even if we follow the complete "Buffett investment equation," our results are likely to differ from his -- and not in a good way.

Rules for managing risk

Here are some of the risk-management rules I follow to reduce the pain during a flat or down market:

• Never invest too much of your money in one sector. The probability that you'll lose a lot of that money increases drastically. It doesn't matter how much you think the sector is undervalued. Sector bets are dangerous -- period!

• Don't be afraid to switch your stance toward a specific stock or a sector if the facts tell you to do so. One good way to eliminate emotional pain is to use automatic stop-losses to drop a stock if it posts a double-digit decline. Flip-flopping is bad if you are running for president, but it's a necessary skill in investing. Unless you have developed a disciplined way to deal with money-losing positions, one day you likely will have your gains wiped out or severely reduced by a prolonged bear market. Consider the shareholders of Bear Stearns (BSC, news, msgs). Or look at MoneyGram (MGI, news, msgs) or First Marblehead (FMD, news, msgs), both down more than 90% in a year.

• Don't take a full position to start, even if you are a contrarian investor who likes to average down on stocks that are going through a serious correction. I usually begin with roughly one-third of my mental maximum position. You have to leave yourself some room for errors, as you're certain to make quite a few of them. Markets do overreact, but they also tend to be right over the long haul. So don't be too stubborn.

• Don't invest more than 15% of your money in any one stock, no matter how cheap you think it is. (That includes positions you average down several times as well.)

• Don't argue with the Fed in the short term. For example, don't go 100% short on gold or commodities while the Fed is cutting rates irrationally. I don't care how passionate you are about it or how wrong you think the Fed is; the Fed controls the dollar-printing press. It will win any short-term battle by default.

• Don't listen to fools who tell you that you can time the market. You might as well try to win the lottery. Stay fully invested. If you aren't feeling good about the market, hedge with low-beta stocks or short sells.

• Don't be afraid of short selling. That's the smartest thing you can do to reduce the overall volatility and risk in your portfolio. It is not easy, and it requires a different approach, but it can pay major dividends over the long haul. (Read my journal entry "5 rules for selling short" for more.)

• Don't be afraid to disagree with everyone. But if you do go against the crowd -- say, by shorting fertilizer, China or dry-shipping stocks -- make sure you have enough in reserves to remain solvent if the crowd turns out to be right for a while.

Stay safe, and feel free to visit my Skeptical Capitalist blog or e-mail your comments to me at skepticalcapitalist@gmail.com.