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 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 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 25 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. How do I compare the performance of my Super in the market?
A. Check your current Super fund’s investment asset allocation and compare between funds with a similar asset allocation exposure.
Do not rely on the fund name or a performance ranking. For example the range of growth exposure for a “Balanced” investor varies markedly. If one Balanced fund has 60% exposure to growth assets and another one has an 85% exposure to growth assets, it should be fairly obvious which one will outperform if share markets are performing strongly. But if the opposite occurs then an inevitable outcome will ensue.
Reading through the websites of some prominent Superannuation funds worries me incredibly as I suspect many investors are taking far more risk than they know about or more risk than they should.
Once you are comparing on a like for like basis, then compare the relative performance, considering fees, the volatility and the capital risks taken to generate the returns. Ensure that you are investing in line with your Risk profile and appropriately for your investment time frames.