One of the first things we do with new clients, after discussing their needs, goals and what they want to achieve, is to do a risk profile assessment.
It is an important tool that is often overlooked or misunderstood however is fundamental in long term investment planning to help you achieve your goals.
So what is your risk profile?
Your risk profile is the result of an assessment that captures how much market volatility you are willing to be exposed to in an investment to achieve your goals. To understand it properly some brief background information is helpful in the form of investment theory fundamentals.
A few investment theory fundamentals:
- Markets, and indeed the broader economy are inherently cyclical, that is, they go up and they go down, but over the longer term there is an upward trend.
- Time reduces volatility. The risk of a negative return in an investment over a short time period such as one day or one month is relatively higher than the risk of a negative return across a longer time period, for example ten years.
- There is a positive correlation between risk and return. That means an asset that has a higher potential risk in the short term is more likely to generate a larger positive return in the longer term
- Different assets carry different levels of investment volatility or risk. That means that if a particular investment has the potential to achieve a higher total return in a given time period, it will also have the potential to generate a higher loss in value over the same period.
- At the lowest end, assets such as cash and cash equivalents, are considered low volatility as their returns are relatively more consistent than an asset with a higher risk profile such as shares. This is shown in the graphical representation below. Note this is for illustrative purposes only and actual positions on the graph may change in relative or absolute terms depending on specific assets, markets or stage of a market cycle. Their relationship in real life is not linear.
When we make a risk assessment, we do so with a specific questionnaire that meets all the financial rigour for accuracy, repeatability and ease of use. We classify our clients into one of ten profiles. These are: Extremely Risk Averse, Risk Averse, Defensive, Defensively Cautious, Cautious, Cautiously Balanced, Balanced, Growth Seeker, Wealth Accumulator, the Speculating Accumulator. This classification will influence the investment recommendations we make.
In understanding these facts, when we look at a person’s risk profile, we are not looking at how much return they want to achieve, we are looking at how much volatility they are comfortable taking on. We then aim to make investment recommendations that adopt the lowest volatility or risk required to achieve that person’s goals, within their tolerance.
Sometimes of course, there is a gap between what someone wants to achieve and how much risk they are comfortable taking on. This is one of the most dynamic aspects to our client service and where our clients often say we add the most value. We always advise that our clients must be comfortable with the level of volatility they adopt. You need peace of mind as well as returns and one at the expense of the other may either leave you missing your targets or overwhelmed with the stress of the portfolio you have invested in to achieve your targets. In situations where there is a gap between the risk profile you need to achieve your goals and the level at which you are comfortable, beyond adjusting one’s risk tolerance position to achieve your goals, other options include reassessing those goals, or changing the time frame. We often discuss this reframing with our clients.
Another way that returns are optimised for a given risk is by active diversification. In investment theory there is an optimal position called the ‘efficient frontier’. This is the point where returns are maximised for the lowest possible risk. It is a horizontal parabolic curve as shown below. At either side of this efficient frontier, returns are reduced and/or risk adoption is higher. We work with our investment partners to achieve diversified and optimised portfolios to generate the ideal return-volatility trade-off for our clients. This is a dynamic process that is actively adjusted in line with market movements. The efficient frontier is illustrated in an example below. The proportions of assets are for illustrative purposes only and may change as markets change.
When you are considering your goals, remember the importance of a risk profile to influence how you can achieve them with the peace of mind that your long-term investment structures are appropriate for you.
Active management with professional independent advice and support can not only help you achieve your goals but do so without undue stress and worry.
|– Your risk profile is the level of volatility you are willing to take on to achieve your investment and life goals|
– You should undertake a scientifically rigorous risk profile assessment with an independent investment adviser to get an accurate understanding of your position
– The risk assessment will help classify you into a category from extremely risk averse to speculating accumulator
– Dynamic client service means we work with you to align your goals with your timeframe, your current situation and your risk profile, bringing all into balance
– The investment objective is to invest in the lowest volatile option for your profile to achieve the returns you seek
– We can reduce risk or volatility in the longer term through active management and diversification across assets and asset classes to help you achieve your goals
Talk to us about understanding your risk profile and how it can impact your investments