Have you ever been a passenger in a car that was being driven too fast?
Or in a car that was being driven too slow?
These questions are about risk tolerance…
Risk profiling is integral to the investment process. It underpins decisions about making an investment, and plays an essential part in ensuring the suitability of investments for clients. It also improves the quality of advice and brings added credibility, explanation and rigour to the investment advice offered.
Risk profiling can help you deal with the risks that you may not even know exist? It can allow you to efﬁciently prioritize and plan resources for critical strategic and operational risk mitigation.
All investors have differing attitudes towards risk. When it comes to investing, it is important to consider your risk profile or tolerance carefully, including how comfortable you are with the possibility of losing money, or that returns on your investments could vary widely from year to year.
Understanding your personal risk tolerance will help you choose an appropriate asset allocation – the following points can help you to determine an investment mix that’s appropriate for your needs.
How would you describe your investment experience and understanding of financial markets?
- Just started investing in the last year
- You understand the basics of investing
- You have been investing on your own for several years and are reasonably confident of your knowledge of financial markets
- Your knowledge of financial markets is well above average and you make investment decisions confidently
To establish an investment strategy that suits your profile of risk and will be comfortable with, you need to consider the possibility that the value of your investment may decline even though this may be temporary. Are you prepared to accept the possibility of a negative return at any time in exchange for potentially higher long term returns? What percentage of your money would you be prepared to invest in higher-risk investments?
Which of the following is important to you:
- Avoiding any short-term losses
- Receiving regular income from investments
- Long-term growth in the value of investments
- Protection against inflation
In October 1987 the stock market fell more than 20% in one day. If you owned an investment that fell by 20% in a short time what would you do or what did you do in 1987:
- Sell all of the remaining investment (Conservative)
- Sell a portion of the remaining investment (Conservative to Balanced)
- Hold the investment and sell nothing (Balanced or Aggressive)
- Buy more of the investment (Aggressive)
Investment Goals and Objectives
Why are you investing? Is it for something in the near future (new car, or down payment on a home) or something farther off (a young child’s education or your own retirement)? If your investing goals are short term you want your money to be there – with interest – when you need it. Therefore you will need to focus on relatively short term investments like term deposits or a cash management trust. If on the other hand, you are investing for the long term, you may be able to afford to take some risk in pursuit of a higher return. Shares, property, and growth orientated managed funds which historically have provided higher returns than fixed interest or cash over time, may be more appropriate.
When do you expect to need to access all or part of your investments:
- Less than 1 year (immediate access)
- Less than 2 years (short term)
- 2 to 5 years (short to mid-term)
- 6 to 10 Years (mid to long term)
- Over 10 Years (long term)
Liquidity / Cash Requirements
How much money do you need to keep available for emergencies such as house repairs, a dental emergency or serious car repairs? These emergencies can be a serious setback if you are not prepared. The amount of your emergency fund will depend on your current lifestyle and expenses. As a general rule you should have about 3 months of income set aside to meet emergencies without needing to rely on credit cards. A cash management trust that pays high interest can be a good place to keep emergency funds.
Age and Income
|RISK PROFILE||INVESTMENT STYLE|
|Conservative||Your primary investment goal is capital protection. You require stable growth and/or a high level of income, and access to your investment within 3 years.|
|Cautious||Your primary investment goal is capital protection. Investors in this risk profile require fairly stable growth and/or a moderate level of income. Your investment term is 3 years or more.|
|Moderate||Your primary investment goal is capital growth. You can tolerate some fluctuations in the value of your investment in the anticipation of a higher return. You don’t require an income and you are prepared to invest for 5 years or more.|
|Moderately aggressive||Your primary investment goal is capital growth. Investors in this risk profile can tolerate a fair level of fluctuations in the value of you investment in anticipation of possible higher returns. You don’t require an income and you are prepared to invest for 5 to 10 years.|
|Aggressive||Your primary investment goal is long-term capital growth. You can tolerate substantial fluctuations in the value of your investment in the short-term in anticipation of the highest possible return over a period of 10 years or more.|
Determining your Risk Profile
FinaMetrica is a globally recognised risk profiling system that has been widely used by leading financial advisers to help determine your personal risk tolerance. The FinaMetrica Risk Profile test is a questionnaire that can be completed online in 15-20 minutes and provide you with a suggested asset allocation of defensive and growth assets depending on which of the seven possible Risk Groups you belong to (see below).
Understanding your Risk Profile will help you select investments that are appropriate for your personal risk tolerance and forms the foundation for making long term investment decisions.
What is your true investment risk appetite?