Q. In your weekly Q and A column you regularly refer to the importance of determining your Investment Risk Profile.  What  should an investor consider in determining their risk profile?

A. 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 that will trade off against each other:

“Risk Tolerance”, this is the level of risk you feel comfortable with.  If you worry about your finances and it keeps you up at night, you may be exposed to too much risk. As we get older it is common for our tolerance for risk to diminish. In determining your risk tolerance a Financial Planner will typically complete a questionnaire with you.  In determining your risk tolerance, issues to consider 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. Risk required is largely determined by the rate of return required to achieve a goal.  So if you require a return of say 9% long term to achieve your objective, you will need a higher 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 modelling the outcomes for portfolios based on various conditions.  For example, a stock market crash, a shortening of the investment time frame due to early retirement due to illness or an increased cost of the goal such as children’s education.

You can have different risk profiles based on the specific financial goal.  Assess each of the above criteria and then adjust your risk profile for each of your goals based on the criteria.

If you are saving for a holiday and your time frame for investing is 12 months, even if you are comfortable with volatility in your investments, you should be conservative with your risk profile 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 volatility in your portfolio, you may need to accept greater levels of volatility based on the returns you would need to generate to meet your goal and because you have plenty of time for your funds to recover if markets were to fall.

It is common for trade-offs to be required in order to build an appropriate risk profile.  In balancing the conflict between risk required and risk capacity you need to consider the consequences of either exposing yourself to too much risk or not enough.  The types of trade-offs you may need to consider could be; increase your savings rate to compensate for lower levels 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 pool of capital required, 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.

Follow Andrew on Twitter @AndrewHeavenFP. This article was originally published in The Australian