Your investment risk profile is a measure of how comfortable you are with different types and levels of investment risk – your feelings about and tolerance of risk.
Why do you need to know your investment risk profile?
For many, perhaps even most, investing can be emotionally challenging; the possibility of losing money, even a little bit, can stir up feelings of anxiety or even downright fear.
Apart from creating these unpleasant emotions it can also trigger reactive investment decisions which could result in a much more unfavourable financial position.
We are often advised that shares are a long game. Over the long term, despite dips, shares tend to perform better than cash or bonds. But you have to have the stomach to stay the course through dips.
For some those dips (which could be as much as 25% and more) cause a sense of panic prompting a reactive decision to sell. Rather than riding out the market fluctuation, selling in this reactive way more often than not results in no return, or even a loss.
Your personal situation can also play a significant role in how comfortable you are with risk: it would be much easier to take a long view if you are 40 and holding shares which take a 25% downturn compared with how you might feel at 65.
The Art and Science of assessing your investment risk profile.
The Science: Much like an ‘IQ’ test with a set of standardised questions, establishing your investment risk profile involves completing a simple, quick risk tolerance psychometric questionnaire. Your anonymous responses, analysed by computer, are statistically compared with a database of answers to show you how you compare to the thousands of other people that have answered the same set of questions.
The results indicate whether you would be considered a very conservative investor, a highly aggressive investor or somewhere in between. This enables your investment advisor to better understand and recommend the best investment types and levels of risk for you rather than relying on your subjective assessment of your risk tolerance which is often not very accurate.
While there are a number of different tests available, we use and recommend a psychometric test developed at Monash University.
The Art: While psychometric tests are very useful and valid tools it is not advisable to rely on them exclusively. A skilled and experienced investment advisor is able to gauge how conservative or aggressive your investment risk tolerance is based on a structured interview they have with you.
Your investment expert, with enough experience, will be able to look at the results from your risk profiling system to see if there is anything that does not match with their interview results. This is important as it helps to highlight where the ‘average’ is not matching your unique profile and indicates where further personal insight is needed to really understand the best type of investment risk strategy for you.
Ok – So your investment risk profile is clear…. What now?
Now comes the task of matching your investment risk profile to your ideal investment plan.
Your investment risk profile is closely related to your investment objectives and your investment strategy. It is important to understand that these three elements are inextricably linked: a change in one affects the other two.
In our e-book “The Investment and Financial Planning Process to Maximise Your Financial Future” you will learn how your investment risk profile is related to your investment objectives and your investment strategy. It is this understanding that will ensure you are creating the best investment strategy for you.
Main image: Sira Anamwong at FreeDigitalPhotos.net
Art & science image: Stuart Miles, FreeDigitalPhotos.net