Every investor should be asking themselves the following question:

"How can I avoid suffering horrific losses from stocks like Enron?"

In light of recent events, the sooner investors confront this crucial issue, the better.

For most people, the accounting scandal has amounted to little more than a tawdry spectacle. I know few individuals who own -- or at least, admit to owning -- Enron shares. But this fiasco presents a strong argument for implementing a risk management system in your own portfolio.

As the fourteen separate Congressional, SEC and DoJ committees investigate this debacle, stock holders should be gearing up to deal with the next disaster (and there's always another disaster just around the corner). Even without any accounting malfeasance, EVERY publicly traded stock has the potential to “Enron.”

Its crucial to make sure that no one disaster results in utterly catastrophic losses -- a lesson that was lost not only on Enron holders, but Lucents' and EMCs' and SunMicrosystems' and a list way too long to detail here.

In my opinion, managing risk and limiting losses are the most consequential -- and under appreciated -- aspect of investing. Loss limitation has a much greater impact on portfolio performance than either stock selection or market timing. How risk is managed has a profound bearing on financial success.

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 United States' largest bankruptcy in terms of lost value -- about 66 billion dollars. 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. Cisco Systems (CSCO), EMC, and General Electric (GE) each "lost" over 100 billion dollars in market cap from December of 2000 to their recent lows. Even if Enron disappears completely, its total shareholder losses would be about 30% LESS than any of these three companies.

That’s truly astounding -- Enron is relatively minor when compared to other recent market calamities.

Collectively, Lucent (LU) shareholders would have been better off owning Enron instead. From its peak, the 3.42 billion shares outstanding in Lucent stock dropped from a high of $80 to a recent price of $6. That's over a 1/4 trillion dollars in capital wiped out; Losses from Lucent are equivalent of four Enrons.

Its not only the "single digit" disasters that see this type of huge capital destruction. Even mighty Microsoft -- with a market capitalization of $343 Billion dollars -- has suffered enormous losses. In terms of value destroyed, Microsoft lost 20% more than even Lucent did. From its peak of $120, to its recent price under $61, more than $300 billion dollars in MSFT shareholder valued has disappeared.

And, its not just the tech sector where shareholder losses accrue: Since December 2000, pharmaceutical giant Merck dropped $84.2 billion in value, while oil colossus Exxon Mobil lost over $52 Billion of market cap.

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

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.

It’s that simple: Size buyers and sellers move equity prices . . . And, the vast majority of that volume comes from Institutions. Mutual funds, trading desks, trusts, specialists, insiders, and hedge funds collectively buy and sell many, many more shares of stock than do individual investors. These Institutions have a much greater collective impact on equity prices than do individuals, who tend to buy stock in 100 or 1000 share lots.

When the big guns decide to change their holding, share prices move substantially. Unlike individual investors, large funds cannot merely add or subtract a position in a single day. For any given stock in their portfolio, they may own tens -- or even hundreds -- of millions of shares.

Getting into or out of these positions can take days, weeks, even months. The technical terms for their impact on price action is "accumulation" or "distribution." The process of institutions building or unwinding positions is the single biggest factor pushing share prices around.

Take the recent action in Tyco (TYC) as an example. Institutions own 91% of the float (that's the stock that's actually traded). They drove the share price down 38% -- from $45 to $28 -- then back up 32% to $37 -- and then down another 41% to under $22 -- in five trading days. That should give you an idea of the potential hurt selling institutions can put on a stock. That's a 34 billion dollar loss in market cap, followed by an 18 billion dollar bounce, capped with a final 15 billion dollar drop.

No doubt, institutions are the market's Elephants. They are huge, lumbering beasts capable of destroying anything in their path. You and I and other small investors are the gazelles of the savannah. We may not be able to knock down trees or intimidate lions, but we can move much more quickly than these behemoths do. The investor that fails to learn how to move quickly eventually gets trampled.

Institutional Ownership and Enron
This relates directly to Enron's stunning decline from over $90 to well under a buck.

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.

What's more, these selling institutions have no incentive to publicize their actions. In fact, its just the opposite: if they figure out something negative about one of their large holdings, they would rather the rest of the world not know about it -- at least not until they are finished selling.

The savvy institutional players who realized early on that something was rotten in Denmark -- or rather, Houston -- kept their mouths shut and their trading desks busy.

The Importance of Limiting Losses
That's where intelligent risk management and loss limitations makes a huge difference in a portfolio's performance. You could have bought Enron at its peak, and using a modest stop loss strategy, limited your losses dramatically. Here's an example of how even a outrageous calamity like Enron need not be a total nightmare to a well prepared investor with a good risk management strategy in place:

Lets say someone was foolish enough to rely upon the analysts who all had "Strong Buys" on Enron in 2000. Our hypothetical investor (lets call him "Ken") got suckered into ENE at the worst possible time -- he bought 1,000 shares at its peak price of $90.

Ken uses the very simplest loss limitation – a straight 15% stop loss. We went over this in some detail this last year in Seven Rules to Improve Your Portfolio.

Stop losses prevent minor problems (like Enron) from becoming major catastrophes.

Ken employed this simple but effective tool when he bought the stock at $90. At the same time, he put in a "good till canceled" 15% stop loss -- at $76.50. Towards the end of the year, Enron had broken $80 and was sliding further south. By mid-December '00, the stock was flirting with Ken's stop point. Soon after, Ken was "stopped out" of Enron at ~$76.50.

Still, Ken's a sucker for the hype. He read a few positive articles on the company ( Enron’s Power Play, 10 Stocks to Last the Decade) that got him excited again. As the market bottomed in April '01, ENE appeared to stabilize. Just as Enron rallied to $60, poor Ken went back for more punishment. He bought another 1000 shares, with the same 15% stop in place.

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

Meanwhile, as the stock price slid, many institution HAD no option but to sell the stock. A "Large Cap Growth" fund, by its own charter, may not be allowed to hold midcap stocks. As a widely owned issue like Enron cratered, it created a self fulfilling "deathspiral." Institutions may have been forced to dump shares in order to stay true to their investment stances.

As this was happening, our hypothetical firend Ken remained a true glutton for punishment. During the post-9/11 swoon, he "caught the falling knife," once again picking up 1000 shares of Enron at $30. At least Ken is 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. Ken’s stop loss kicked in -- but not at $25.50 (15% below $30) as hoped for. Ken 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 Ken's execution awful; He was stopped out (for the 3rd time), at $22.50 for a 25% loss.

Before we see total up our investor's losses, please note that Ken 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 sell much worse than his expected 15% stop loss.

Total damages: $30,000, or 33% of Ken'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 99.57% of their capital. Their $90,000 initial purchase is now worth $390!

Poor, unlucky Ken -- with a disciplined stop loss plan in effect -- still has $60,000 of capital left. He has 153 times more investable capital left than the buy and hold crowd! Their losses were 298% greater than his.

Conclusion
Enron as well as other companies stand as important lesson in risk management and loss limitations. Jumbo losers can occur in any publicly traded company. Even "safe stocks" such as Exxon, 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. Investor who fail to learn this lesson -- think of the shareholders of Lucent, Enron and myriad others -- eventually get trampled.

Barry L. Ritholtz is the Market Strategist for a New York brokerage and money management firm. At the time of publication, Ritholtz was either long or controlled shares of Exxon Mobil and Microsoft, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to Barry Ritholtz ritholtz@aol.com.

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