When deciding what to invest, it’s always important to understand your risk. Many investors interpret risk in different ways. Some see it as a need to generate higher returns and others try and avoid riskier investments altogether. Your risk profile can depend on a variety of different variables. In this article we will explain what a risk profile is and also how a risk profile is determined including aspects such as investors attitude to risk and capacity for loss.
A risk profile is the evaluation of an individual’s ability and willingness to take risks. This is extremely important when determining the asset allocation of a client’s portfolio. There is no universally-accepted optimal number of risk profiles. Usually, within the investment industry, the number of different risk profiles range between 3 or 5. It is common practice within the investment industry to use the equity portion of a portfolio as the main defining feature. Therefore, 3 profiles for example, offer high, medium and lower risk. This generally means portfolios with an equity allocation around 70-80% (high), 50-60% (medium) and 30-40% (lower). Many investment firms may offer portfolios at the more extreme ends of the risk spectrum increasing the number to 5, including a very high-risk profile and also a very low-risk profile.
Attitude to Risk
An investors attitude to risk can be defined as the level of risk you are willing to take when selecting investments to reach your desired goals. Your attitude to risk can be seen as a more psychological aspect of determining your overall risk profile and there are many aspects which can affect this.
An individual’s experience and knowledge in investing can affect their attitude to risk. Many investors who have this experience and knowledge of the stock market are more likely to have a higher attitude to risk. For example, an investor who has held their assets through market turbulence in the past, may be more likely to weather the storm if markets do take a downturn as they have experienced this and the market recovery which often follows. Conversely those who have little market experience are naturally more likely to be less risky and so their attitude to risk tends to be lower.
Investing goals can also affect an individual’s attitude to risk and can affect how they think about their investments. For example, an individual with the goal of wealth preservation may be approaching retirement and want to minimise volatility and risk altogether and so their attitude to risk may be low. Alternatively, a younger individual with many years ahead of them may have the goal of wealth accumulation and see risk an important aspect to high growth potential over the long term, therefore, they will be higher up the attitude to risk scale. Attitude to risk is about how much risk an individual is willing to or thinks they can take. Let’s now take a look at how we measure how much risk an individual can actually take.
Capacity for loss
Capacity for loss is about taking the individuals financial situation and whether they have enough income and assets to maintain a suitable level of risk.
There are various aspects which can affect an individual’s capacity for loss. The individual’s financial position is often the most important aspect. For example, what portion of the individual’s wealth does this represent? If this represents a high portion, the client should have a lower capacity for loss as they do not have much else to fall back on if the investments take a turn for the worse. Alternatively, if this represents a small amount, they can afford to take further risk as they have other assets helping them maintain their lifestyle and achieve their financial goals.
An individual’s age can also affect their capacity for loss. If they have a longer time horizon, they have enough time to allow their investments to recover if they experience any downturns. For example, Following the 2000 crash for example, it took more than 10 years before the global stock market fully recovered as the 2008 crash wiped out the prior recovery and took returns into negative territory once again. Therefore, clients with higher risk portfolios should be prepared for very long periods where returns could be negative, and therefore do not need to draw on the investments for many years. The opposite applies for those investors with a short-term time horizon, a lower capacity for loss is likely.
Determining your overall risk profile
Determining your risk profile is a very important aspect when it comes to investing as it also determines the asset allocation of your portfolio which is the main driver of returns. It’s important not to look at the attitude to risk and capacity for loss in isolation and to combine them to achieve an overall risk profile. Alongside your overall risk profile your adviser should also have a good understanding of your circumstances and goals to recommend the appropriate risk profile you should be using, taking everything into account. At Skybound Wealth Management we have built our own risk profiler which accurately determines your overall risk profile by taking into account your attitude to risk and capacity for loss. To speak with an adviser today, visit our website and request a call back.