Risk is a key feature of any investment strategy. It’s a fundamental part of the positive and negative outcomes and is the difference between financial security and stress. Without it, investment portfolios wouldn’t make any money, and savings would erode over time as inflation takes hold.
Why, then, is risk such a misunderstood feature of investing? It’s important to understand that risk doesn’t necessarily mean ‘risky’. High-risk assets can, over time, be highly profitable, while low-risk assets can fail to show any significant growth. Want to know the level of risk that is appropriate for your financial situation and future goals? We’ve got the answers.
What is a risk profile?
A risk profile is an assessment of an individual’s risk tolerance. Risk profiles help investors identify the level of risk they are willing to take and the appropriate investment asset allocation for their portfolios. Risk-averse investors are less inclined to take on risks, while those who seek higher returns are willing to take on more significant risks.
Assets and liabilities are important factors when evaluating investment risk. Investors should consider whether they want to take on more or less risk when evaluating their assets. Investors with large assets and few liabilities tend to take on more risk than those with fewer assets and more liabilities. But this is not always the case.
A risk profile can be developed by using a variety of methods. The standard approach is via a risk profile questionnaire. Financial advisors use this questionnaire to ask investors about their age, major life events, income, credit rating and investment experience. The questionnaire should also include questions regarding loss tolerance.
Why is it important for an investor portfolio?
A risk profile is fundamental to risk management and smart wealth management as it helps mitigate threats and risks to investors’ portfolios.
A risk profile is vital for an investor’s portfolio because investors’ level of risk should correlate to their asset allocation. And it involves dividing investments between the different asset classes and investment types. Asset allocation depends not only on each individual’s risk profile but also on their financial goals and personal circumstances.
Since it measures an individual’s appetite for risk, investors who are risk-averse will tend to avoid risky assets such as stocks, bonds or real estate in their portfolio. Conversely, those who are risk-tolerant will tend to invest in those types of assets.
Given that a risk profile determines the appropriate asset allocation for investment portfolios, once a risk profile assessment is done, an investor’s risk profile is categorised. The investor is then provided with growth and or income portfolios that match their risk profile.
The most common types of risk profiles are conservative, moderate, and aggressive/growth. The difference between these types of risk profiles is the percentage of cash and cash equivalent, bonds and stocks in each investment portfolio. For instance, a conservative portfolio can have 20% cash, 40% bonds and 40% stocks, while an aggressive/growth portfolio can have 10% cash, 15% bonds, and 75% stocks.
Financial providers can further break down the types of risk profiles mentioned previously into moderately conservative, very conservative, moderate growth, and moderately aggressive and very aggressive. To learn where and how to invest money, please speak with your financial asset manager.
Is financial risk dangerous?
Without risk, investment accounts will not make significant gains. What is risk? Well, risk is most often measured by volatility – how much an asset’s return varies. The higher the volatility, the more the price of a security is likely to move over a short period of time, and therefore, the riskier the asset.
In this sense, cash accounts come with limited risk but equally limited potential. As interest rates fail to keep up with the value of inflation, cash becomes a low-risk way to lose money over time. Without understanding the dynamic between risk and return, what it can do for your savings and that it is a fundamental part of investing, people are missing out on opportunities to maximise returns.
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Financial risk is not, on its own, something to avoid. We’ll go into the situations in which you might want, more or less, but ultimately risk is something every investor needs to see returns on their savings.
When should I take on more risk?
If you have a relatively short investment timescale, it might instinctively seem like a high-risk portfolio would be the best choice – if gains can be made quickly, that short timescale isn’t a hindrance. Similarly, those investing for the long-term might want a low-risk outlook to make steady growth more likely.
In reality, the opposite is true. A longer time horizon gives an investor more capacity to absorb risk. If your portfolio grows by 20% over a 15-year period, it matters little that two of those years might have returned significant losses. You’re still 20% up at the end of it all. Alternatively, taking on a high-risk portfolio for a short period of time could result in losses with no time to ride them out.
Ultimately, your appropriate level of risk depends on how much you have saved, how much you want to have at the end of your investment journey and your attitude towards short term fluctuation for long-term gain. Investors that ‘stay the course’ throughout periods of volatility are generally rewarded, but greater fluctuations in value are not for everyone.
How we balance risk/reward
At Moneyfarm, we have seven different risk levels to cater for the situations and attitudes of all of our investors. When you open a general investment account, we’ll ask for some basic information to ascertain the level of risk that suits you, building a picture of how you like to invest and how one of our products can best help you meet your goals.
Generally, our portfolios are made up of a combination of carefully selected equity and bond ETFs and some cash. Equities are seen as the riskier asset class with the potential for the highest returns. Bonds carry less risk and are seen as a safer route to steady (but less significant) growth. The makeup of your investment portfolio will depend heavily on your risk level, with different asset classes chosen to reflect your goals and your financial situation.
All of our portfolios are created and actively managed by an experienced asset allocation team to ensure that the balance between risk and reward is maintained.
Understanding your tolerance for risk
As we’ve established, your tolerance for risk is personal, and it should be a defining feature of your ideal investment strategy. It should be determined based on your financial goals, time frame, and personality.
The ideal risk level is somewhere between risk-averse and thrill-seeker for most people. Most people will be comfortable with a well-diversified mid-level risk portfolio, meaning the risk is spread across several different asset classes so that any losses can be offset with gains elsewhere. Short-term fluctuations can be managed in this way across the different risk levels.
It’s not always easy to know how accepting of risk you’ll need to be to reach your financial goals, but it’s important to get to grips with this information. Only when you fully understand your attitude to risk can you build a portfolio that reflects you as an investor. At Moneyfarm, we do this for you – we’ll match you with a portfolio that reflects your investor profile and is built and managed by a team of experts to help you achieve your goals.
Finally, an investor’s attitude to risk is not a stationary thing. Circumstantial changes, geopolitical or economic developments, and a change in life goals can affect an investor’s appropriate level of risk. With Moneyfarm, you’ll have the scope and freedom to adjust your level of risk as you invest with us, or simply talk through your options with one of our highly qualified investment advisors.