Savvy investors understand their risk profile
Savvy investors play an active role in profiling their own risk. Read on to find out how you can play an active role in shaping your own financial future.
All types of investments require that you take on some degree of risk. Cash, for instance, carries an inflationary risk (as your holdings could devalue over time), investment property carries the risk of non-occupancy, and equities the risk of capital loss through company insolvency or other less drastic economic factors that cause share prices to fall.
Investment risk measures how sure you can be of achieving your investment objectives. The relationship between risk and return is fundamental to all investments. The more risk you’re willing to take on, the greater the potential return should be.
Three types of risk
When determining your risk profile, three types of risk must be considered.
- Risk required quantifies the amount of risk required to achieve your investment goals. For example, if you have a medium-term investment horizon (say, five to 10 years)and need a substantial return, you may need to assume a high level of risk by investing in a single asset class fund such as an equity fund.
- Risk capacity measures how much financial risk you can afford to take without compromising your goals – your capacity for loss. A young investor with a long-term investment horizon (i.e. 20 years) would have far higher risk capacity than an older investor with less time, or poor cash flow and increasing expenses.
- Risk tolerance is your emotional willingness to take on risk. Would you be able to sleep at night if your high-equity retirement unit trust portfolio plummeted by 25% ?
What is risk profiling?
Risk profiling uses the three risk types to determine the optimal level of risk for your investment portfolio. Important considerations will include your overall investment objective, your age and time horizon, your cash flow and your required income.
Your risk profile can – and is very likely to – change over time. You may decide to start a family, buy a new house or business, or scale down your accommodation upon retirement. Financial advisers are required to review your circumstances and risk profile at least once a year.
Risk profiling methods
Questionnaires are the most common risk profiling tool. These usually include questions about your current assets, debt, income and potential income, your age and the amount you require when you retire. They also include questions that aim to determine your risk tolerance and emotional comfort levels. Calculators have been developed which are like questionnaires, but potentially more accurate in that they assist in weighting the answers.
Investment professionals believe that there’s a need to develop new tools which take into account your financial genetics (your family members’ attitudes towards money) and your personal financial history. Another highly-effective but little-used risk profiling method is to keep an ongoing personal financial diary which tracks your financial habits as your personal circumstances change.
Risk profiling can be risky. One of the biggest challenges is measuring risk tolerance, since it’s tricky to quantify how each individual thinks. Even the most sophisticated psychometric calculators cannot take into account the myriad of differences between us. Many people aren’t able to predict how they might react to a big drop in their portfolio value if the market falls substantially. There’s also the potential for a conflict between financial risk factors and your emotional appetite for risk: regardless of how you feel, you may have to take on a higher degree of risk than you feel comfortable with to meet your financial objectives.
Another snag is that you may have different risk profiles for different investments. Investing towards your children’s education is very different to saving up for a dream holiday, so individual portfolios may be required to take these differences into account.
What’s more, financial advisers are human beings with their own levels of risk tolerance and sets of biases. This is unavoidable: we are all guilty of projecting our life experiences onto friends and colleagues in a genuine attempt to assist.
More pros than cons
The rewards of risk profiling are still thought to outweigh the snags, which is why it forms an integral part of the investment process. If conducted thoroughly and without bias, risk profiling forms a fundamental tool in determining how you allocate your assets.
Very importantly, it creates self-awareness and assists in your understanding of the investment process, thus helping you to remain focused and calm and to contact your adviser when your circumstances and attitudes change. What’s more, it encourages you to assert yourself in your relationship with your adviser.
Risk profiling doesn’t guarantee that you’ll never run into financial problems. But it does provide comfort for both you and your adviser that a thorough process has been followed in planning for your financial goals. A good adviser will also help coach you to manage your risk tolerance – such as by assisting you in understanding what to expect before you invest. For example, investors who know that the South African equity market has experienced an average decline of 16.1% (from peak to trough) every calendar year since 1980 will be better equipped to deal with these declines when they occur in future, and to avoid panicking.
Should you wish to discuss your risk profile, contact your financial adviser or find out more about Prudential unit trust funds by contacting our Client Services Team on 0860 105 775 or at firstname.lastname@example.org