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Portfolio Planning—Budget for Risk: Yoshikami

Erik Snyder | Lifesize | Getty Images

Only return matters some say. We couldn't disagree more.

In constructing your portfolio you should employ a decision making process called risk budgeting. It is one component of a multi factorial based construction process that we at DWM employ as we invest assets; you can adopt this same perspective as well. It's the foundation of a prudent investment strategy and can guide your investment decisions as well as mitigate risk to acceptable levels.

Risk budgeting is an art and scientific process combined. Facebook has a risk profile that varies from a company like Johnson and Johnson. You need to know the risk profile of every asset you invest in. It requires one to look at both micro and macroeconomic issues and make judgments on what potential outcomes might occur based on probability analysis. You cannot ever be neutral or not take a position because non-action is essentially deciding by passive choice.

You must always decide.

For every unit of return you seek to capture, you must absorb a certain amount of risk to capture that return. You must seek return but not be overly defensive lest you end up like those managers that have been sitting in cash for the last three years while the market climbs.

(Read More: George Soros, Pimco Turned Bearish on Gold)

As you make investments in your portfolio, analyze the potential upside and downside probabilities for every asset that you invest in; analyze the magnitude of variation that might occur. Said another way, question how extreme the volatility up or down might be and let that dictate your decision on whether to invest in the asset. Don't get caught in a name like Zynga without a clear understanding of the risk associated with the position.

For safety's sake, seek assets with an upside that is greater than the potential downside (although this can vary depending on the situation or the market environment). If the position has the opportunity to have significant upside but greater risk, this may be acceptable as long as the level of risk-taking in the overall allocation is not skewed greatly by the inclusion of this asset. This is an important issue because it illustrates how every asset decision is not made solely based on its own merits but in part made based on its contribution to the overall portfolio allocation.

Construct a risk budget that you believe provides the best chance for success while limiting downside volatility. Your overall focus should be on risk adjusted returns; know the risk you are absorbing. In other words, don't go too far out on the ledge for portfolio returns if the potential downside risk is too great.

(Read More: Cramer's Holy Grail of Stocks)

Traders may dispute this conservative perspective and suggest that you can take more risk as long as you have a long term time horizon. In general, that is true but the question is one of survivability.

Will you hang in there for a 10 or 15 year time frame and absorb huge losses while waiting for the promised turnaround? Will you stay with the strategy when a loss of 50% occurs? Most won't. Just look at the number of investors bailing out of Apple; panic can emerge suddenly and you need to decide how much fluctuation you can take and how long you can wait for results.

Market participants tend to be very emotional. Are you when volatility occurs? If so, make sure you have developed your strategy with a risk budget in mind. It will serve you well when panic in the market set in.

(Read More: Investors - Have You Planned for This?)

Michael Yoshikami, Ph.D., CFP, is CEO, Founder and Chairman of the DWM Investment Committee at Destination Wealth Management. Michael is a CNBC Contributor and appears regularly on the network. DWM is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutions and individuals around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010, 2011 and 2012.

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