Experience teaches wisdom, and what better advice to take than that of one the most experienced and successful investors of our time Warren Buffett. One of his most famous quotes states, “Rule number one, never loose money. Rule number two, never forget rule number one.” It’s a humorous but pragmatic way of looking at risk management with regards to one’s portfolio.

Oftentimes investors get so caught up, anticipating significant portfolio returns that they sometimes forget about protecting their principal. As an investor, balancing return with your risk tolerance and employing the relevant risk management techniques is crucial. Risk management is the process of analyzing exposure to risk and implementing measures to limit such exposure. SSL recommends that you consult your wealth advisor and assess your risk tolerance and structure your portfolio accordingly.

All investors are unique and have different levels of tolerance for risk. Several factors such as age, salary and expenses, health, family, and personality play a role in determining an investor’s risk tolerance. Conservative investors are exceedingly apprehensive about losing their principal and seek to minimizing risk; they accept a lower rate of return in exchange for added peace of mind. On the other hand, aggressive investors prefer to maximize the return on investment with a more flexible strategy, and are willing to accept a higher degree of risk.

Where do you fit? Are you, conservative, aggressive or somewhere in between? Determining your goals, initial outlay, expected rate of return and investment horizon will help you identify your risk tolerance. Once you know this, you will be better able to evaluate investment opportunities in light of the expected risk and return as well as employ techniques to mitigate the risks involved.

Although there are many risks to consider, we will focus on only two in order to demonstrate the thought process investors should follow when making prudent decisions. These are market risk and inflationary risk.

Market risk is the potential for an investor to experience losses from fluctuations in securities prices. In other words, if the particular market you have invested in whether the stock market or the fixed income market experiences a decline, it follows that the value of your investment will also decline. While the overall risk inherent in the individual markets is not diversifiable, fortunately risk can be mitigated by spreading your portfolio into different markets, thus reducing exposure to any one market. To illustrate, when bonds are up, stocks often tend to be down and vice versa. Portfolio risk can be further alleviated by investing in different segments or sectors of that market. For example, in the equity market one inexpensive way to do this is via mutual funds. To put this into perspective, if you invest in four different sector funds such as technology, health care, utilities and financials, then your overall equity risk will be reduced as their performance tends to be unrelated.

Inflation continues to be a concern for consumers and investors alike. Inflationary risk is the loss of purchasing power that comes with inflation. The only sure way to guard against this is to invest in assets that have historically outpaced inflation, such as stocks. For example, Carreras Ltd (CAR) gained 51 per cent in 2010 (on a nominal basis), beating inflation, which was 11.8 per cent. Likewise, if an individual had invested in the Jamaica Stock Exchange (JSE) Junior Market Index, he or she would have seen a real return of 41.2 per cent.

For the average investor, it is therefore advisable that between 30 and 40 per cent of your assets be invested in stocks or other equity related investments. This will allow a portion of your portfolio to grow faster than inflation without putting the majority of assets at risk. You should probably ladder the remaining portion of your portfolio in safe fixed-income securities like CDs or T-bills. This allows a set portion of your portfolio to mature periodically to meet liquidity needs and protect you from interest rate risk. At the same time, you should avoid a high concentration of long-term bonds in your portfolio as bonds are the single most vulnerable asset class in this regard. This is because most bonds receive a fixed coupon rate that doesn’t increase. For example, if you invest in a 30-year bond that pays a 10 per cent interest rate, while inflation is greater your purchasing power will be reduced.

While risks are inherent in any investment, prudent investors should identify the specific types of risks associated with their portfolios and implement ways to mitigate against them. This in turn will aid in safeguarding your principal investment by keeping your portfolio balanced.

Deon McLennon is an Equity Trader at Stocks & Securities Ltd (SSL). You may contact him at dmclennon@sslinvest.com.