Determining your Investment Risk Profile

Investing fundamentally considers both risk and return. Every investment is subject to the two concepts, so it is key to appreciate them when investing. Whilst returns are desired, they are unpredictable and unfortunately cannot be controlled. It means understanding risk is key, as risk can be managed to some extent. By determining your investment risk profile, you are able to have a level of control over risk. It allows you to be able to manage the risk you take on in investments, in which risk management is argued to be one of the most influential factors to an individual’s success when investing.

Knowing your risk profile enables you to invest within your own capacity, tolerance, and appetite for risk. It allows you to develop an awareness of risk which you can apply to investments. Knowing your own level of risk not only gives you comfort when investing but can help you work towards your own personal goals.

A risk profile is useful for developing your investment strategy, as it supports you in choosing investments which match a level of risk that is suitable for you. It also helps you to react appropriately to volatility and losses in your investments and will help you to remain rational amidst the emotion of investing. Determining your risk profile provides you with a solid foundation for the decisions you make. Ultimately it helps you in managing the amount and types of risk you take on in your investments and can help you to work towards returns you aim to generate.

Your investment Risk Profile

A risk profile considers your capacity, tolerance, and appetite for risk. These three items help you to form the basis of your investment decisions. The risk profile considers how you would apply risk to financial situations and help to determine a level of risk you are comfortable taking on as you invest.

Investment Risk Profile

Investment Risk Appetite

When you consider your investing journey, you will have set your goals and have an idea of what you want to achieve. Risk appetite is the amount of risk you are willing to accept to achieve those goals. It determines the risk you need to take on to achieve your aims. It will be used to determine your choice of investments that will help you meet your goals.

  • High risk appetite means you are willing to take on large amounts of risk in order to achieve your goals.
  • Low risk appetite means you are looking to take on smaller amounts of risk to achieve your goals.

Your risk appetite is typically reflected in choices of assets and investments. Having a high-risk appetite may mean you invest in highly volatile assets which have a greater return potential. A low risk appetite may mean choosing to invest in low risk assets, opting for those which have a greater guarantee of returns without the need for unnecessary risk.

Depending on how you have chosen your goals may affect your appetite for risk. Having ambitious goals will require greater returns and so greater risk may be needed. More modest goals means returns don’t need to be as high and so the level of risk is often lower.

Your risk appetite will set the foundation of your risk profile. It considers what you wish to achieve and provides a broad overview of the risk you are prepared to take to achieve your goals. When it comes to determining your own risk appetite, you need to be able to decide just how you feel about risk. It will help you determine what amount of risk you are willing to take on.

Investment Risk Capacity

Before you invest, you need to be able to understand your own ability to take risks. You may have an idea of the risks you wish to take as you consider your goals and how you want to meet them. However, you will have to take into account how capable you are to take on such risks.

Risk capacity is the risk you can afford to take. It applies your financial situation and how much can you afford to lose. You should only ever invest what you can afford to lose, and so you need to be able to think about the risk which your financial situation allows. It means you need to consider your income, your savings, and your need for cash.

This also means you also need to understand your goals, your time horizon for investing and your age and lifestyle. Depending on where you are in life, you may have different capacity for risk and how much you can afford to lose. Your situation will more than likely dictate how much risk you can take on financially.

The table below shows some examples of the factors which may affect your capacity for risk, and how they may impact your ability to take on risk

Low Risk Capacity
Factors
High Risk Capacity
Low Income High
Unstable Financial stability Stable
Younger Age Older
Short Term Horizon Long term

For example, those with larger amounts of income and a longer time frame can afford a greater capacity of risk. Their investments will have greater time to grow and they will be able to take on riskier investments. However, a shorter time frame or less income may mean you need access to money at some point sooner rather than later. It would mean you have a lower capacity to take on risk.

Please note that your risk capacity is specific to you. Therefore, you need to consider everything which investing will affect and determine how that will decide your ability to invest.

Understanding your capacity for risk will help you choose investments which keep you within your capabilities. Whilst you may identify a wish to take on a certain amount of risk, you need to know if you are in a position which allows you to do so.

Investment Risk Tolerance

As you choose investments, there is always that possibility that you lose money. Assets can be volatile and may fluctuate in value. As risk affects returns, you need to be prepared for the possibility that your investments don’t go completely to plan.

Your tolerance to risk is your ability to withstand losses (or the possibility of losses) and how much you can endure. It boils down to your level of comfort with risk. Whilst you may have the appetite and capacity to take on risk to meet your goals, you need to think about how comfortable you are when that risk actually appears and starts having an impact.

A high-risk tolerance investor is typically able to deal with greater levels of volatility and losses. Low risk tolerance investors may worry at the slightest hint of deviation and so would be unable to bear too much risk. You may be able to decide your comfort with risk based on the following two assets:

Asset A shows small amounts of volatility and the investor only ever sees a small dip in returns. On the other hand, Asset B shows large amounts of volatility. Whilst the Asset B eventually makes a solid return, there was almost a stage where it lost all of its value. An investor with a low risk tolerance would be much happier with Asset A. Someone with a high tolerance may be content with investing long term in Asset B. You should consider which you would be more comfortable with if that was your money and you were in that situation.

As risk tolerance considers the possible deviations, it means it is possible to put measurements to figure out your risk tolerance. There will likely be a range of varying results which you deem acceptable when investing and would feel content with if they occurred. You can decide on a number which is suitable to you and invest with that in mind.

For example:
  • An investor with a high tolerance to risk may be comfortable seeing their investments lose 50% of their value as they aim to maximise returns.
  • An investor with low risk tolerance may only tolerate a 5% loss before they become uncomfortable taking on any more risk.

Your risk tolerance not only considers your level of comfort with risk and how much you may be comfortable losing. It is also useful for determining how you may react in a situation where you lose money. You will want to choose a level of risk which you are able to bear and wouldn’t react extremely to if losses were to occur.

Someone with a large tolerance would likely accept variations that may come with risk. They would feel the need to do nothing if losses occurred. This is because they’d feel comfortable waiting out those losses in hopes for the eventual returns they could receive. On the other hand, some may be unable to handle seeing their investments go down and would be inclined to sell so they don’t see value further decreasing.

You need to consider if you are able to stomach volatility/losses and to what extent. If not and you take on large risk, you may panic and sell and lose money. Your risk tolerance will help you remain rational and provide you with greater comfort as you hold your investments.

Knowing your risk tolerance will help you decide both your investments and how you act once you own those investments. Having a high-risk tolerance means a greater level of comfort for ups and downs as well as loss. Those with a high risk tolerance may choose higher risk investments. Having a low tolerance means you should possibly be considering investments which have a lower risk. They tend to be less volatile and typically provide a greater guarantee of steadiness in their returns. Ultimately your risk tolerance decides your level of comfort when taking on risk and how you will act if losses occur.

Your Investment Risk Profile

Your investment risk profile will help guide your decision making and the strategy you use when choosing your investments. Ultimately your risk profile comes down to risk:

  • Appetite – Willingness to take risk.
  • Capacity – Ability to take risk.
  • Tolerance – Determines your limits and boundaries of risk.

When you consider these three, you can begin to put yourself into a profile which suits how you want to approach your own investing journey. Your risk profile determines what kind of investor you will be.

When you determine your risk profile, it will fall somewhere along the following scale:

Conservative

A conservative risk profile suggests you will be an investor who takes low amounts of risk. You may have a low appetite, low capacity or low tolerance for risk and find that you need security when you invest. Typically, returns are considered second best, where you prefer preservation and stability above all.

When it comes down to returns, you may look to achieve your them slowly. There is little risk being taken, and when you do opt to take on risk, it is in a safe and controlled manner. You simply want a greater level of guarantee in your money.

The assets you may invest in will more than likely have greater assurances in their returns and be suitable for the risk being taken. Investments will typically be debt oriented, in order to provide a steady income and moderate growth.

Moderate

Having a moderate investing risk profile means you lie somewhere in between the risk spectrum. You want a solid balance between risk and returns. Whilst you are willing to invest in riskier assets, you still require a level of security.

In your risk profile, you may have a high-risk appetite, but a moderate capacity and tolerance for risk. Perhaps, you have a greater capacity and tolerance for risk, but a low appetite for it. Whichever way you have determined your capacity, tolerance, and appetite, you are probably aiming to achieve your goals quicker than a conservative investor whilst still being wary of risks.

The investments you choose may offer greater returns, but you will offer some safety. It is likely the risk you take on can be managed appropriately. Investments may include a mix of assets such as high-risk securities which are diversified within a fund to ensure risk is spread and eliminated to an extent. They provide both solid growth and a suitable balance between your needs.

Aggressive

Being an aggressive investor means you aim to maximise returns by taking on the most amount of risk. You would typically exhibit the most willingness for risk, have the capacity to do so and be able to tolerate volatility within investments.

Aggressive investors typically seek growth over the long term and are willing to tolerate both the potential upswings and downswings. You may be likely to reach your goals the quickest and/or achieve the most success when investing. However, you would be putting your money at the greatest risk. It means you may have the greatest possible chance of losing it.

The investments chosen will be high risk. They will offer the highest potential with returns, whilst being most volatile and putting investors’ money at the most risk. An aggressive investor may seek to invest in individual securities such as stocks and shares to achieve their ambitions.

In Summary…

You should be able to identify the general kind risk profile you feel comfortable with. You should understand the type of risk you want to take on, the amount of risk you are able to take on and how you will tolerate risk. Ultimately you will be able to determine the type investor you want to be.

Understanding your investment risk profile allows you an element of control over risk. It can help you to choose investments which are right for you. Your investment risk profile allows you to manage risk in a way which is suited to how you wish to invest. It will help you find the right balance between risk and return, which can give you the best chance of success when investing.

 

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