Most people base their investment strategies on the returns they want, but they have it backward. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It'd be great if we could get plump returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve some possibility that we'll lose money.

The good news is, once you've identified just how you feel about risk, you're well on your way to choosing a portfolio that will maximize your returns according to that comfort level.

Of course, this isn't just hypothetical theory for modern investors. The 2000s have brought us two wrenching bear markets, a mere six years apart. (Maybe there was something to all that Y2K hullabaloo after all!). Have you been able to hold on -- or did you panic and sell? That's the true test of an investor's risk tolerance: the ability to cling to those shares as they become worth less and less, while clinging to the hope (based on history) that they will one day be worth more and more.

So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you're retired, can you rely on other resources such as Social Security or pensions, or would you have to go back to work (and how would you feel about that)? How you answer those questions will lead you to your risk tolerance. The lower your stomach for portfolio ups and downs, the more your portfolio should be in bonds.

As an extra aid in determining your mix of stocks and bonds, consider the following table, from William Bernstein's The Intelligent Asset Allocator:

I can tolerate losing ______% of my portfolio in the course of earning higher returns

Recommended % of portfolio invested in stocks

35%

80%

30%

70%

25%

60%

20%

50%

15%

40%

10%

30%

5%

20%

0%

10%

So, according to Bernstein, if you can't stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in stocks. Sounds like a very good guideline to us.

OK, you now know how much you should have in stocks. But what kind of stocks? Let's find out by playing a game in our next installment.