These three ideas are usually what come up and excite us when we talk about finance and investments in particular. On the other hand, however, three concepts also usually pop up during a “finance conversation” that worries us.
So you see, these thoughts always come together in finance and it’s normal. It’s okay to be excited and anxious at the same time when exploring, or even just hearing about this subject. Knowing how you feel about this topic is essential when you want to make wise decisions in order to maximize your hard-earned or “hard-saved” money. Why? Well, because it’s your money.
We can’t stress this enough, but there’s a way to make it work. Always. There is a way to make your chances tip on the favourable side. And how do you do it? By educating yourself. Not only about the markets and the different investment choices that’s widely available to you, but educating yourself about you. Now, the first thing that you would want to know about yourself is your risk profile. Knowing your risk profile is a great (and the proper) way to kickstart your journey towards sustainable wealth creation or, to put it simply, future-proofing your life.
Risk profiling is defined as an evaluation of an individual’s need, willingness, and ability to take risks. It essentially identifies the amount of risk you are prepared and comfortable taking. It helps you understand your attitudes towards investing and helps you predict possible actions you could take when faced with unexpected events in the future. It is important to note that what may be true to you regarding your risk profile will not be the same for other people and vice versa. This is because no two people will have exactly the same choices and actions when it comes to confronting certain situations as these two — your choices and actions — are conditioned by your past experiences, personality, mindset, lifestyle, current environment and/or circumstance among many others.
There are three elements that compose your risk profile. These are: risk required, risk capacity and risk tolerance.
As the name suggests, risk required is the amount of risk “needed” to meet your financial objectives. It is simply the risk that your required level of return needs. Is it required? Despite what it’s called, Dr. Greg Davies says in his article that this is not required or considered compulsory by any governing body or regulations encompassing finance and investments. Because this component is usually evaluated by financial advisors or of those in the wealth management industry, this may not be something that you can accurately figure out for yourself — although you can get a general idea based on your goals. The higher the returns you expect or need at a shorter time horizon for example, the higher the risk required would be (you’ll see what we mean by this as you read through!) — and so we won’t be focusing too much on this. If you fancy reading through some materials about this, then this article by Dr. Greg Davies would be a great read!
Your risk tolerance basically refers to the amount of risk you’re comfortable taking — emotionally. It’s all about how much of the market’s ups and downs (well, mostly the downs) you are able to handle. The market’s volatility, referring to how much and how quickly price changes in a financial market, may be something that excites some people, but for most it’s what they fear about investing. And it’s okay if you’re part of the latter! Always remember that there’s always something out there for everyone — no matter what type of investor you are. You just have to educate yourself. Alright, moving forward from our pep talk, the evaluation of risk tolerance depends on many factors such as your timeline (investment time horizon), goals, age, portfolio size and income.
The time horizon indicates the amount of time you want to achieve a goal. Consider it as a deadline. A good rule of thumb here is that the longer the time you are allotting to achieve a goal or a certain amount of money, you’re open to experiencing more risks. The more time you have to achieve a goal means more time to put in money in your investments and deal with the market fluctuations (Want to read more on how this is so? check out our previous article on financial markets here). For example, Person A who aims to earn Php 1,000,000 to buy a car in 5 years can take more risk than Person B who aims to earn the same amount of money but in a span of 2 years.
Your goals refer to your financial or investment objectives. The bigger your goals are, the higher the returns you would need for it. And as we all know with investments, the higher the returns, the higher the risk that accompanies it.
The same concept as time horizon applies to this. The younger you start, the more time you have on your hands to achieve your goals and the higher risk you can take. Also, the younger you are, the more time you have to handle market fluctuations. In addition, you have additional time to earn money to place on your investment than say, people nearing their retirement age or are retirees already who would focus much more on keeping their money safe and stable instead of growing it. Although, this is what usually happens, know that everyone is different so don’t be too pressured if you feel that just because you’re too young, you’d have to take on so much more risk than what you’re comfortable with!
Firstly, your portfolio refers to your collection of investments — including all asset classes such as stocks, bonds, cash and cash equivalents, and commodities. Market fluctuations may lead to really high returns to huge losses and how much you earn or lose depends on your portfolio size. The larger the portfolio size, (it is assumed) the more tolerant to risk an investor is. This stems partly from the fact that a bigger portfolio size means the more experienced an investor is because portfolios are generally built over time. Another factor would be that the more money you’ve already injected to investments, the more comfortable you are (as it is usually assumed) with facing higher returns and risking bigger losses.
Income Level/ Financial Resources
I know what you’re thinking, and you’re right. Income and risk tolerance generally have a positive correlation. That means that the bigger your income, the more risk you can tolerate or be comfortable taking.
Now that we’ve tackled some of the factors that contribute to your risk tolerance, know that this evaluation leads to three main classifications of investors based on their risk tolerance level.
An aggressive risk investor usually has more experience in terms of investing and has a broader portfolio. That is to say that while they experience huge returns when the market is doing good (which we refer to as a bull market in finance), they also take on huge losses when the market’s performance deteriorates (which we call a bear market). While huge losses may discourage some investors especially in equities — leading them to panic sell, they tend to hold on to their investments.
A moderate risk investor tends to take risk but at a more modest level than that of the aggressive investor. They tend to invest in less risky asset classes such as bonds and mutual funds that pay well in the long-term. But they can also tolerate equities such as those of Blue-Chip stocks (these are huge and recognized companies that have a long history of sound and quality performance in the stock market) and preferred stocks. Although they also shoulder some losses, they neither lose nor earn as much as the aggressive risk investor. Investors falling under this category usually strive to take a 50/50 ratio between risky and safer asset classes or tend to go around this ratio in managing their portfolio.
Lastly, the conservative risk investor, as you’ve probably guessed, takes on less risky or volatile investments. Some low risk investments they usually engage in are money market funds, certificate of deposits, and certain types of bonds such as government bonds. These investments offer stability and protection in exchange for lower yields.
Risk tolerance is usually measured using questionnaires and if you want to give it a try (you know, taking your first step to knowing thyself) then you can check out this assessment tool by Rutger’s University.
Risk capacity refers to the amount of risk you can afford. While the risk tolerance is the amount of risk you are willing to take, risk capacity refers to the risk you can actually take. Oftentimes, risk capacity relies on your current and actual financial resources and is therefore objective and considered as the “computed dollar value of the risk exposure you can take in proportion to your assets” by Zoe Financial (btw, check out the link and read through their article!). Whereas, risk tolerance is affected by many factors but is primarily reliant on your feelings and emotions — generally your personality. Because of this, you may need the guidance of a professional to help you calculate and understand your risk capacity.
Keep in mind that your risk profile may change over time and so it’s important to regularly evaluate yourself; probably at least once a year, if you’re an active investor, or at every major turning point in your life (for example, getting your first job, having a salary increase, getting married, having kids or retiring). Your risk required, risk tolerance, and risk capacity may not always match up, and so the main goal is to find a compromise between them. It’s important to find the investment that would not cause you sleepless nights or anxiety when the market is not performing so well (and mess up your rationality when you gain high returns!) and is within the boundaries of what you can actually afford to lose financially. Then, voila! You’ll be able to make smarter investment decisions and strategies in the future to maximize your money.
Now that we’ve gone through what comprises a risk profile, we certainly hope that you know thyself a little bit more than you did before reading this. Interested in your risk profile’s application in strategizing your investment journey? Watch out for our next article on asset allocation strategies. Meanwhile, check out UP JFA’s Pisopedia!💚