Q. What is an investment risk profile and what should an investor consider in determining their own 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 provides a framework that will enable you 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. In determining your risk tolerance you would typically complete a questionnaire. The questionnaire will identify your behavioural 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. For example if you require a return of 8% 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 taking into consideration the chance of negative performance from markets. Testing for risk capacity involves assessing financial outcomes for portfolios based on various market conditions.

You can apply different risk profiles based on your specific financial goals. If you are saving for a holiday and your time frame for investing is 12 months, even though you may be comfortable with higher levels of risk, you should be conservative with your investing because your risk capacity is constrained due to the time frame of the investment. By contrast if you are saving for retirement which is 20 years away, and you are uncomfortable with portfolio risk, 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.

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, start drawing on retirement savings later or reduce the size of your estate that you leave the family.

Broadly speaking, to achieve higher investment returns you need to be prepared to accept higher risks of capital loss or volatility. Whether you should accept those risks or not should be based on your risk tolerance and balancing your required risks and capacity to weather risk. All of this should be considered in light of your stage of life, your investment timeframe and your income and future security of income.

Gaining an understanding of your attitude to risk and the consequences of other risk factors is critical in building an investment portfolio. It is important that you are realistic in your expectations about investment returns and also the risks you face. Whether it be the risk of not receiving a high enough return or the risk of chasing too high a return based on all the factors discussed.

Q. I am age 68 and retired. Can you give me a general idea of what exposure to growth investments I should be looking to have in my Allocated Pension for the long term in retirement?

A. It is generally accepted that growth assets will outperform defensive assets such as cash and fixed interest in the long term. As such it is important that your overall portfolio has exposure to growth assets to protect against the long-term impact of inflation.

There is no definitive answer as to how much you should invest in growth assets in retirement. How much you choose to invest in growth assets should be determined by your appetite for risk, your life expectancy, your income needs and your ability to weather a market downturn and allow for a market recovery.

Diversify your portfolio amongst a range of investments, both growth; such as shares, property and infrastructure as well as defensive; such as cash and fixed interest. These asset classes should be diversified by type and a mix of Australian and International.

Retirees typically feel comfortable with exposure between 40% and 60% of their assets to growth investments. The funds may be invested by investing by using a diversified manager or by using sector specific specialist investment managers.

When utilising a diversified manager strategy, the trustee manages the asset allocation across both growth and defensive assets in accordance with the stated risk profile. Allocated pension payments are taken from the returns from all assets.

When utilising sector specific specialist investment managers, the funds are invested into individual managers in different asset classes. The advantage of this approach is you can specifically elect where you draw your pension payments from.

Assuming you draw income from your Allocated Pension at 5% per annum and you withdrew the money from the defensive assets within your portfolio, on a 50% growth exposure, you have 10 years “breathing space” before being forced to sell growth assets in the event of a share market downturn. If your portfolio was structured as 80% Growth, then obviously you would only have 4 years. You need to determine how comfortable you would feel in this scenario and how big an income buffer you would require.

Both investment strategies have their merits however most retirees I speak with prefer to control where they draw their pension income from.