Q: How do I determine my investment risk profile?
A: An Investment Risk profile is an assessment of your willingness and ability to take risk with your portfolio. The process of Risk Profiling builds a framework to determine what investment asset classes you should consider and importantly what you should avoid.
Your risk profile is built upon three primary considerations; tolerance for risk, risk you would be required to take to generate sufficient return and your capacity for risk.
Risk tolerance is the level of risk you feel comfortable with. As we get older it is common for our tolerance for risk to diminish. A risk tolerance questionnaire will identify your responses to a range of scenarios which will include your level of experience as an investor, your level of understanding of how investment markets work, your personal view of risk, your confidence in making your own investment decisions and how you feel when markets rise and fall.
Risk required is the level of investment risk you would need to take to achieve your goals. If you require a return of 6% long term to achieve your objective, you will need exposure to growth assets in order to achieve the goal.
Risk capacity is the level of financial risk you can afford to take given the time frame for investing, your available funds and considering the chances of negative performance from markets. Testing for risk capacity involves assessing financial outcomes for portfolios based on market conditions.
You can apply different risk profiles based on your specific financial goals. If you are saving for a holiday in 12 months, even though you may be comfortable with risk, you should be conservative with your investing because your risk capacity is constrained due to the time frame. By contrast if you are saving for retirement which is 30 years away, you may need to accept greater levels of risk to generate the returns to meet your retirement goal, recognising you have time for your funds to recover if markets were to fall in the shorter term.
Trade-offs may be required to satisfy your risk appetite. The types of trade-offs you may need to consider could be; increase your savings rate to compensate for lower rates of returns, reduce your living expenses in retirement so the pool of capital required is less, downsize the family home and invest the proceeds to supplement the retirement savings, defer retirement and save for longer or reduce the size of your estate that you leave the family.
Gaining an understanding of your attitude to risk and the consequences of other risk factors is critical in managing an investment portfolio. Whether you should accept those risks or not should be based on your risk tolerance, balancing your required risks and capacity to weather risk. This should be considered in light of your stage of life, your investment timeframe and your income and future security of income.