Smart Ways to Look at Risk by Carrie Schwab Pomerantz on Creators.com

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Smart Ways to Look at Risk

Dear Carrie: I am 45, single, debt-free and own my home. How aggressive should I be with a $360,000 portfolio? — A Reader

Dear Reader: The classic answer to a question like this would be to take a look at your goals, how long you plan to keep your money invested and how comfortable you are with the ups and downs of the market. Put it all together, and you will have an idea of whether you are what financial experts would call a conservative , moderate or aggressive investor. If only it were that simple!

First, make sure you understand the difference between calculated risk and foolish risk; too many people get into trouble because they never really think through their approach, or appreciate what could happen. And as you decide how aggressively you should invest (aggressive usually means investing heavily in stocks), also be sure to consider other aspects of your financial life.

At 45, you still have a lot of time ahead of you; let's say 20 years before retirement. You're single, so presumably you don't have others financially dependent on you. And being debt-free, you've already cleared an important financial hurdle. If you're comfortable with short-term market volatility and won't be tempted to run for the door at the next downturn, you may want to consider growth-oriented investments.

But if we've learned anything from the recent recession, it's that it's easy to think you're an aggressive investor — willing to take on more investment risk for higher returns — until you're on the other side looking at your losses. So, let's put some things in perspective.

LOOK AT THAT NUMBER — AND BEYOND

Your nest egg has the potential to grow significantly over the next 20 years — and if you're mostly invested in stocks, you might be able to achieve a higher return than if you put most of your money in fixed income or cash. To put this in dollar terms, an average annualized return of 8 percent (possible for an aggressive portfolio) on $360,000 compounded over 20 years would give you almost $1.7 million. A 5-percent annualized return in the same time frame (more realistic for a conservative portfolio) would yield just under $1 million. That's a big difference. But the key question is whether you're willing to take on the added risk for the potentially greater return. Because while the numbers look enticing, stocks are volatile and there's no guaranteed return. You have to be willing — and able —to lose as well as gain. And in fact, many investors (even those with diversified portfolios) merely treaded water for the last 10 years.

Overlooking the potential downside is where a lot of folks, who think they're aggressive investors, miscalculate.

BE AGGRESSIVELY SMART

Even if you think you can handle the market ups and downs and decide to invest more aggressively, be smart about it. What you need to do is take calculated risks. For instance, putting too much of your money in just a couple of stocks would be a foolish risk. If those stocks go down, your whole portfolio goes down with them.

But diversifying your investments by buying stock in a variety of companies — both U.S. and foreign, large and small, and in different industries — is a calculated risk that offers the possibility of both higher returns and greater protection from volatility. I can't stress enough the importance of this type of diversification.

PROTECT YOURSELF

Also, never forget that your portfolio is only one piece of your financial picture. Before you take on more risk in the way you invest, make sure you're covered in others. This includes:

— Short-term needs. Do you have an emergency fund in place? You don't want to be forced to sell investments in a down market. Consider having enough money to cover three to six months' of essential living expenses in cash.

— Job security. If you're worried about your employment future, it's probably best to be more conservative. Again, this means more cash.

— Health and disability insurance. Health insurance is a must. Disability insurance is also a really good idea. Once again, you don't want to have to sell your stocks to cover an emergency.

— Other financial responsibilities. Consider whether there may be other people, such as aging parents, who may need your financial help in the future.

CONTINUE TO SAVE

Even if your current situation is stable, I encourage you to continue to save. Retirement is really expensive, so be sure to calculate what you will really need to maintain a comfortable lifestyle. Especially if you decide to invest more conservatively, you should save more aggressively. For example, if you can save $15,000 a year for the next 20 years, and earn an average compounded rate of 6 percent, you will add more than $550,000 to your nest egg.

Bottom line: There isn't one "correct" strategy when it comes to risk. But whatever you decide, be sure you understand how those risks affect not only your portfolio, but also how they affect every aspect of your financial life.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER (tm) is president of the Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.