Risk Profiling – Managing Investment Risk
There are a number of elements that are vital to developing a successful financial plan. Goals, time frame, level of liquidity. But possibly the most important, and often most misunderstood and overlooked, is risk profiling. If you, and your financial advisor, don’t fully understand your risk profile you will potentially face disappointment, either in lower-than-expected returns, or in unexpected losses.
So, with interest rates uncertain, and talk of a looming recession, we thought it might be a good time to explore what risk profiling is, and give you an idea how to think about your personal risk profile.
What Is A Risk Profile?
A risk profile is defined as ‘the evaluation of an individual’s willingness and ability to take risks’. This can be applied to any aspect of life, but in a financial context, it is used to direct decisions on the combination of financial products incorporated in an overall financial plan.
Risk & Return
We’ve said this before, but it bears repeating. The higher the return, the higher the risk. This is why having an accurate picture of your risk profile is so important. If you are committed to chasing high returns, you need to be prepared for the lows. If you are not, you will likely struggle dealing with those lows. This can impact your emotional well-being and your future approach to investing.
In our article on Modern Portfolio Theory, you see that investments can be mapped, and where an investment falls on the graph will determine whether it suits your risk profile or not.
The Time Of Your Life
No two risk profiles are the same. Like most things in life, the lines are not black and white.
Whilst you undoubtedly have an overarching, natural risk profile, how willing and able you are to take risks changes over time, and depends on your circumstances.
When you are young and still have 30 or more years of working life ahead of you, taking a risk on a high-return investment can be exciting, not to mention profitable. And you have time to recoup any potential losses.
When you are saving for a house, or have just started a family, your appetite for risk will likely be reduced. And when you are looking at imminent retirement, it will probably reduce still further.
Time Heals All Wounds
It’s not possible to talk about risk profiling without mentioning the importance of time horizon. High-risk investing often requires a longer-term approach. Sure, you may make a quick buck and be able to get out with a profit in a short timeframe. But if things don’t go as you expect, you may need time to ride out the low. Losses are only on paper until you divest yourself of an investment. So if you have a short, or fixed, investment horizon, high risk is even more of a gamble.
Defensive vs Growth
In essence, defensive assets like bonds and term deposits, are low return and, as the name implies, low risk. Growth assets, like shares and property securities are higher risk. How you combine these assets, what percentage of each you have in the financial mix, will impact both the volatility and the return you achieve, and will depend on your risk profile.
You can read more about how to structure a plan that fits your profile in our article on Ingredients of a Financial Plan – Portfolio Management.
Many investors like to include diversified funds in their portfolios. These are usually offered in a range of risk classes. Each fund provider will have their own names for the classes, and their own specific percentage mix, but common terminology is:
Conservative – this class of fund will have a high level of defensive assets, with a small percentage of blue-chip, lower risk shares. Returns will be on the lower end of the spectrum, but will generally be consistent and somewhat predictable
Balanced – a balanced fund will incorporate defensive assets, low-risk blue-chip shares and a small percentage of higher risk investments. Returns will be slightly higher, and a little less predictable. You may experience losses, but they are not likely to be very high.
Growth – the balance in a growth fund will tend towards higher risk shares and investments, with a small amount of defensive investment providing an underlying base. Returns can be high, but so can losses.
High Growth – this asset class will provide the highest highs, and most likely, the lowest lows. The vast majority of this class is invested in growth assets, with a focus on returns rather than stability.
Even if you don’t invest in diversified funds you can apply these risk class descriptors to your own bespoke portfolio, based on the investments you’ve included.
What Is My Risk Profile?
There are two aspects which combine to determine your risk profile – your risk capacity, and your risk aversion.
Capacity – this refers to your ability to weather losses in a practical sense. Someone with low debt, a high income and a solid asset base is financially more able to suffer losses than someone on a lower income, who has high levels of debt.
Your capacity to weather loss is also situational. If you are saving for a home, or approaching retirement, you are likely more sensitive to loss than someone who is saving for a long-distant retirement.
When thinking about your risk capacity, you need to take into account how much is too much to lose.
Aversion – this refers to your emotional response to loss and is much harder to quantify, especially if you haven’t experienced financial loss in the past. This aspect of risk profiling is tied to your nature, the influence of those around you, and your experiences in life. If you have experienced financial hardship, you are likely to be more risk averse than someone who has not. Studies have shown that people who have experienced recessions, or as far back as the Depression, are, broadly, much more conservative in their risk profile[i].
Studies also suggest your personality type and overall level of optimism in relation to the world will also play a part here[ii]. If you generally believe things will turn out well in life, your job, the world, you are more likely to be prepared to take risks, and emotionally recover from them, than someone who is pessimistic about their job or the world in general.
How Do I Work Out My Risk Profile?
An experienced, qualified financial advisor will be able to help you determine your risk profile using a combination of quantitative and qualitative questions.
But this is not a set and forget. As we said earlier, your risk profile will change over time, so it’s important to revisit it regularly. Life milestones, such as marriage, purchasing your first home, investing in a business, or approaching retirement are often good opportunities. But you don’t have to wait for these times.
A good way to measure if your risk profile is still appropriate is to evaluate how you feel when, or if, you suffer losses. If a loss causes you sleepless nights and anxiety, it may mean that you should dial back your level of growth assets. However, if it doesn’t bother you, it might be worthwhile looking at increasing those assets.
Check out our article on Active Management and Realignment for some tips on what to look at when considering a change in your risk profile.
Whatever you do, it’s always best to get the advice of a qualified financial advisor.
If you would like to understand your own risk profile, Manly Financial Services have the expertise and experience to help you, and to assess if your current financial plan is consistent with your profile. Give us a call on (02) 9976 3388 for a chat, or contact us via the below link.