Look risk in the eye and make it a good friend

No pain, no gain.” How many times have you heard that cliché to describe something you didn’t want to do? Unfortunately, investing carries a certain amount of risk, and with it can come some pain, but also some gain.

Regardless of the type of investment, you must weigh the potential reward against the risk to decide if the pain is worth the potential gain. Understanding the relationship between risk and reward is a key piece in building your personal investment philosophy.

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 other asset classes (such as equities) involve a higher level of risk. However, even with traditionally safer investments, risk is never completely absent and returns are never guaranteed.

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

Most investors while making an investment consider less risk as favourable. The lesser the investment risk, the more lucrative is the investment.

However, the thumb rule is the higher the risk, the better the return. 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.

Although “the higher the risk, the higher the potential return,” 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.”

To understand this relationship completely, 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 that level. A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it also may fail dramatically.

Your comfort level with risk should pass the “good night’s sleep” test, which means you should not worry about the amount of risk in your portfolio 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 risks than older ones can because the former have more time to recover if a 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 that you’ve got to control your losses. But how do you do it?

Follow the trend: 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) that are 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.

Rebalancing: 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. They will sell off those assets and buy more of the stocks or ETFs that have underperformed. This can be a forced means of buying low and selling high.

Position sizing: Another way to play defense is to simply limit your exposure. If a given investment is riskier than others, you can choose not to invest in it or to invest only a small amount of your capital. The easiest way to lower your stock market risk is to shift some of your capital to cash.

Stop loss orders: You can place a stop loss order with your broker that will automatically sell out all or part of your position in a given stock or ETF if it falls below a preset price point.

Of course, the trick is to set the price low enough that you won’t get stopped out on a routine pullback, but high enough that you will limit your capital loss. Placing a stop loss order is one way to limit the damage to your portfolio and force yourself to follow a strict defensive discipline.

Diversification: The idea behind investment diversification is to buy asset classes or sectors that are not correlated. That means that if one goes up, the other is probably going down.

Diversification has been a lot more difficult to achieve over the past few years as many asset classes have become highly correlated.

Diversification is a good strategy to limit your risk, but it only works if the assets you buy are truly uncorrelated. Make sure you look at relatively recent performance rather than relying on historical relationships that may no longer be working.

Risk is a natural part of investing. Investors need to find their comfort level and build their portfolios and expectations accordingly.