Courtney C. Lipsey We’ve discussed the relationship between reward and risk many times. Investors who are pursuing Financial Autonomy through investments must balance the desire to reach their goals as quickly as possible with a risk level that allows them to sleep well at night.
You will be asked to complete a questionnaire about your risk profile when you first start working with a planner. You’ll also be asked to repeat the process periodically in future years to ensure that your thoughts haven’t changed. This week, I wanted to spend some time discussing risk profiles, their relevance, and the challenges investors face.
1. What is a risk profile?
A risk profile is a measure of your tolerance for risk. In an investment context, we refer to the variance of outcomes when we speak about risk. An investment with low risk might return 6% in the best case and 2% in the worst case. A high-risk investment could have a return that is 30% in the best case and -30% in the worst. The high-risk investment has a wider range of possible outcomes, which means that the result is more uncertain.
2. Identifying your risk tolerance is important
Your financial planner will use the information in your risk profile to determine what investments you should make. It is important to accurately assess your risk profile because it plays a major role in determining the investment strategy you choose. Your risk profile is a way for you to communicate with your planner exactly what you’re comfortable and not comfortable doing when it comes time to invest.
3. Different types of risk profiles
Risk profiles are usually broken down from low to high risk. Different planners and organizations use slightly different terminology, but in our practice, we start with defensive, which is the lowest-risk option. The next step up is conservative, balanced, growth, high growth, and then, finally, conservative.
Someone with a low-risk profile, who is also defensive in their risk assessment, would probably invest all of their money in cash and term deposits. Someone who does not like volatility would be this person. The other extreme is the high-growth end. This is for those who are looking to invest for the long term and want to be aggressive. Investors with a high-risk profile tend to invest in property or shares and may borrow money to increase their return. They typically have very little cash and invest in low-risk investments.
The majority of people are somewhere in the middle. The most common profile among our clients would be growth. The middle-ground profile will include a combination of growth assets, such as bonds and shares, with some defensive assets. As an example, the asset allocation target for a risk profile with a high growth potential would be 80% cash and fixed interests and 20% shares or property.
4. Determining your risk profile
A questionnaire is used to determine your risk profile. Some questionnaires are more detailed, and others are not. All of them will make you think about how much volatility you can tolerate. You’ll be asked questions such as “If your investment value dropped by 10%, for how long would it take to recover?”
5. How to deal with a partner who disagrees with your risk profile
Couples often face this problem. We find that one partner is usually interested in finance and has read books, listened to podcasts, and become familiar with the volatility of investing over the long term. However, the other partner in a couple is unlikely to be interested at all. In a couple, it is common for people to play to their strengths. This can make developing an investment strategy a bit difficult.
The person who has less interest in finance will usually have a lower risk profile.
In order to resolve this issue, we recommend that both parties agree on their goals and objectives. Once these are nailed, we can get a better idea of the timeframe and what may be needed.
It is important to agree on your goals. The couple may have one member who is highly motivated to retire earlier while the other deems it a sign of laziness. Different levels of readiness may exist in regard to saving capacity. Savings are a form of happiness that can be deferred. Saving for the future is a good thing, but your partner may prefer to spend more now.
If we are able to reach agreement on the goals, then we will look at each person’s risk profile and try to find common ground. They both need to find something they can live with and that will also help them achieve their goals. It may be that the partner who is willing to take on a higher risk will have to adjust their strategy to one that is a bit more conservative at first.
Separate investments are the other option. Superannuation is a good example. This allows the person with a higher tolerance for risk to invest aggressively, while the more cautious person can use a conservative mix.
6. How risk profiles influence investment decisions
The risk profiles determine the types of investments and the allocation of each type to a strategy.
Let’s take an investor with a balanced risk profile as an example. This would mean that our target asset allocation is 60% growth assets and 40% defensive assets.
We’ll look for solutions to fill these allocation buckets when we build an investment portfolio. In the bucket of growth assets, we’d include Australian and international equity funds. Maybe property funds, too. Cash, term deposits, and bonds will be considered for the defensive asset portion of your portfolio.
The risk profiles are closely linked to the portfolio of investments that you would create.
7. Investment Time Frame and Risk Profiles
If you have a high-growth, aggressive risk profile but are working toward a goal with a timeframe of two or three years, the mix of investments that are normally associated with this type of risk profile will not be appropriate. A risk profile with a high growth rate would require a longer timeframe, usually seven years.
A conservative investor may choose to invest their superannuation more aggressively in the knowledge that the funds will remain invested for 40 years or longer and the volatility they experience is irrelevant.
Financial planning is a blend of risk tolerance, timeframe, and the art.
8. Your risk profile might change over time
Over time, it’s not uncommon for someone’s risk tolerance to change. When people first start investing, they tend to be more conservative. It is a sensible approach, as you can get started without too much worry and stress. After investing for some time, we often find that people tend to increase their risk tolerance and become more comfortable with the volatility of the investment markets.
A change in investment timeframe is also possible. In your 30s or 40s, you may be happy to be a high-risk investor. However, if you are a few years away from retirement, you will want your investment profile to be a bit more stable.
