Finding comfort level with risk to get firm portfolio

No pain, no gain”. How many times have you heard and read that cliché to describe something you didn’t want to do? Investing carries a certain amount of risk, and with it comes some pain or gain.

You must weigh the potential reward against the risk to decide if the pain is worth the potential gain.

As an investor, understanding the relationship between risk and return is critical: the higher the relative risk, the larger the possible return.

With some asset classes the risk is small (cash, for example), while others (such as equities) carry a higher level of risk.

Warren Buffet, one of the most successful investors ever, is famous for spelling out the two most important rules of investing: Rule 1, Don’t lose money and 2, Never forget Rule 1.

Every saving and investment product has different risks and returns. Differences include: how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be.

The higher the risk, the higher the potential return, yes, but you need to consider an addition to the rule so that it states the relationship more clearly: “The higher the risk, the higher the potential return, and the less likely it will achieve the higher return.”

You must know where your comfort level is and be able to correctly gauge the relative risk of a particular stock or other investment.

All investors need to find their own comfort level with risk and construct an investment strategy around it.

Your comfort level with risk should pass the “good night’s sleep” test, which means you should not worry about the amount of risk so much as to lose sleep over it.

There is no “right or wrong” amount of risk; it is a personal decision for each investor. However, young investors can afford higher risk than older ones because the former have more time to recover if disaster strikes.

If you are five years away from retirement, you probably don’t want to be taking extraordinary risks with your nest egg, because you will have little time left to recover from a significant loss.

You can see that even a relatively small loss can require a pretty big offensive push to recover. It’s easy to say you’ve got to control your losses. But how do you do it?

Follow the trend is your friend until it ends. One way to manage investment risk is to commit to only buying stocks or exchange-traded funds (ETFs) in an uptrend and to sell them once they violate their trend line support.

You can draw your own trend lines by connecting a series of higher lows on a chart, or you can use a moving average. If the price breaks that support level by a predetermined amount, you sell.

Longer-term investors may try to manage risk by periodically selling stock investments or asset classes that have come to take up too much of their portfolios.

Investment diversification targets asset classes that are not correlated.

That means that if one goes up, the other is probably going down. However, it has been difficult to achieve over the past few years as many asset classes have become highly correlated.

Investors need to tie rik to comfort levels when building portfolios and expectations.