The secret to investment risk profiles – do they work and will they keep you out of trouble?

The secret to investment risk profiles – do they work and will they keep you out of trouble?

A key objective of investing well is to avoid unexpected (and nasty) surprises. Shocks that knock you sideways are never fun. Investment risk profiles are there to act, not as shock absorbers, but as shock avoiders.

What is a risk profile?

That very much depends. Enter ‘risk profiling tools’ into Google and you will get over 40 million results.

What does Investopedia have to say on the subject?

A risk profile is an evaluation of your willingness and ability to take (investment) risks.

“A risk profile is important for determining a proper investment asset allocation for a portfolio”.

That sounds good. But what exactly is meant by ‘risk’?

What is risk?

In investment terms, the word ‘risk’ is bandied about at random to explain a host of different and unconnected things. Many of the explanations are meaningless and, in some cases, blatantly wrong.

Here are some big risks to avoid when it comes to your investments:

  • Running out of money before you run out of breath
  • Investing in a fraudulent investment and losing every penny
  • Selling out of your portfolio at the very bottom of a market downturn
  • Being unable to meet your future goals
  • Not being able to access your money when you need it

No risk profiling tool can prevent you becoming a victim of fraud.

What is volatility?

Risk is frequently confused with volatility (of portfolio returns). ‘Portfolio’ in this term refers to your investment holdings. Investment values rise and fall based on supply and demand and positive and negative economic news. The ups and downs of the markets are of the utmost importance here.

Investors should not fear volatility, but they should fear loss. When investing, emotional responses play a large role (rather larger than they really should). Take two portfolios that, to the uninformed, look relatively similar from the outside. One portfolio has swings in value between +10% and -10% and the other can swing between +35% and -35%.

Few investors concern themselves when the swing is positive. You will pay more attention when the swing is negative. For some investors even a paper valuation of -35% could send them running for the hills.

To understand the difference between risk and volatility watch this short video:

How does a risk profiling tool help?

The purpose of a risk profiler is to match your chosen investment portfolio with your personal needs. This is somewhat like the Goldilocks scenario – you want to avoid a portfolio that’s too ‘hot’ and avoid one which is too ‘cold’. Profiling helps you find an outcome which is ‘just right’.

A portfolio that is too hot for you might blow up, be highly volatile beyond your limitations and be difficult to manage against your goals and expectations. A bucking bronco.

An overly cold portfolio is most likely to fail to meet even your basic future goals. It’s like driving with the handbrake on.

What are the important factors to consider?

Not all risk profiling tools are the same. In fact, assume each one is different. They can be divided into two camps: profiles which help align (and promote) a particular portfolio of the wealth manager you are dealing with. The ‘you scored a 7 so the ideal portfolio choice is pink’ style. And the second camp profiles the individual, not the portfolio.

Consider the following four important aspects:

Capacity

How strong are your financial resources if all goes wrong with your investments? Can you still afford the basics and live a comfortable life, or will you be ruined with even a modest crash or crisis?

Requirements

What are your financial goals and when do you need to meet them? This is based on what you want in the future, minus what you have now, equating to what you need (want – have = need). The ‘need’ in these cases equates to the annual return on your investment portfolio. Do you need inflation plus 2% a year or inflation plus 5% a year in order to fulfil your dreams?

Perception

How do you view the global economy, fiscal and monetary policy, politics and inflation? Do you understand macroeconomics in some depth, or are you more an interested observer? What is your experience of holding, buying and selling investments of any kind?

Tolerance

This is your investment-risk DNA. This differs from other risk-taking you may engage in which is subjective, like gambling or free climbing. The two are not the same. A bomb disposal expert may have a very low investment-risk profile.

A good risk profiling tool is simply a process for discovering your optimal level of investment risk and return, by balancing your requirement, capacity and unique tolerance.

How does my profile lead to a matched portfolio?

Think of your profile as a footpath signpost or a weathervane. It gives you a general direction of travel, but it is not a scientific instrument based on microns.

Ideally, you want a portfolio that can meet all your life objectives on time and in full, but which allows you to sleep soundly at night.

Almost all investment portfolios will be a blend of bonds and fixed income (the safety and defensive component) and company shares (the growth component).

An easy way to visualise the portfolio range is to think of something we all know about – cars.

For the sake of simplification and explanation, compare a Renault Clio car at one end of the spectrum and a Bugatti Veyron at the other end.

In general terms, a Clio isn’t driven at excessive speeds. It’s a town car, known for being economical and safe. It has a five-star NCAP rating and a 96% rating for an adult occupant. It has a top speed of 110mph. According to thecarpeople.co.uk, the typical Renault driver is a female parent aged between 40 and 54 with young children.

The Veyron is extremely fast, with a top speed of 267mph. According to Business Insider, the average Bugatti owner has 84 cars, 3 jets and a yacht. It is difficult to uncover who owns and drives them.

Let’s look at what happens when things go wrong. The entry level Clio has an engine size of 0.9 litres, while the Veyron’s is 8.0. Assume the cars are being driven at 65% capacity (71mph and 173mpg) and hit something hard (the equivalent of a major market event). The results are likely to be quite different.

Your chosen portfolio must be as exciting and safe for your needs, no more and no less. Enjoy the ride.

If you would like an impartial assessment and MOT of your portfolio, contact Capital today and one of our chartered financial planners will be happy to help.

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