The relationship between risk and reward is one we’ve explored many times. Anyone pursuing a Financial Autonomy goal through investment needs to contend with the typical desire to achieve their objectives as soon as possible, whilst adopting a level of risk that enables them to sleep comfortably at night.
When you start working with a financial planner one of the first things they will ask you to do is complete a risk profile questionnaire. They’ll likely also have you repeat this process intermittently in the years ahead to check that your thinking hasn’t altered. This week I thought we’d spend some time looking what risk profiles are, why they’re relevant, and some of the challenges that we see investors face.
1. What is a Risk Profile?
A risk profile is an assessment of your preferred tolerance with respect to risk. When we talk about risk in an investment context, we are referring to the variability of outcomes. A low risk investment option might have a best case return of 6% and a worst case return of 2%. In comparison, a high risk investment might have a best case return of 30% and a worst case return of -30%. This wider range of potential outcomes for the high risk investment means greater uncertainty as to the outcome.
2. The Importance of Identifying Your Risk Tolerance
Your financial planner will use your risk profile to help determine appropriate investments to recommend to you. Because your risk profile has such a central role in determining your investment strategy it is extremely important that it be assessed accurately. You could think of your risk profile as the way to clearly communicate to your planner what it is you’re comfortable with, and what it is you are not comfortable with, when it comes to investing.
3. Different Types of Risk Profiles
Risk profiles are typically broken down across the spectrum from low risk to high risk. Different planners and institutions use slightly different terms but as an example, in our practice we start at defensive, being the lowest risk option, the next step up is called conservative, then balanced, growth, and high growth.
At the low risk end, someone with a defensive risk profile would likely be all in cash and term deposits. This is someone who is uncomfortable with any sort of volatility. At the other extreme, the high growth end, this is for someone looking to be aggressive and is investing for the long term. Typically a high growth risk profile investor would invest in shares or property, perhaps with borrowings to magnify the outcome. They would typically hold very little in the way of cash and low risk investments.
Most people fall somewhere in between. I would say across our clients, the most common profile would be growth. These middle ground profile will have a mix of growth assets such as shares, combined with some defensive assets like bonds. For example the target asset allocation for a growth risk profile would be 80% shares and perhaps property, and 20% cash and fixed interest.
4. Determining your risk profile
Determination of your risk profile is typically done via a questionnaire. Some questionnaires are more detailed than others and none of them are perfect. They will all get you to think about your tolerance to volatility. You will get questions like “if your investment dropped in value by 10%, how long would you be willing to wait for it to recover?”.
5. What to do when you and your partner disagree on risk profile
This is a very common problem that couples face. Typically we find one member of the couple is interested in financial matters, and so has listened to the podcasts and read the books and got themselves comfortable with the volatility that comes with investing for the long term. The other member of the couple, however, likely has no interest whatsoever in these sorts of things. It is very common in a couple that you have people play to their strengths, quite sensibly, but it can be a little challenging when developing a coherent investment strategy.
Usually the person with not much interest in finances will have a more conservative risk profile than the person who is more engaged.
To address this difference we find the starting point is to have them both agree on the goals and objectives. With these nailed down we have a good sense of time frame and what might be required.
Agreeing on goals is no small thing. One member of the couple might be highly motivated to retire early, whilst the other considers that a sign of laziness. There may be different degrees of willingness around savings capacity. Savings after all a type of deferred happiness. One member of a couple might be happy aggressively saving for the future, whilst their partner would prefer more spending in the here and now, with the commensurate happiness this spending is likely to provide.
Assuming we can get agreement around the goals, we would then look at each persons risk profile and see if we can find some common ground. Something they can both live with, but is also likely to make their objectives attainable. Sometimes that might mean the member of the couple who is happy to invest in a high risk investment needs to accept that, at least initially, the strategy will be a little bit more conservative.
The other way to go is to keep investments separate. This happens by necessity in superannuation for instance. In this way the person with the higher risk tolerance can invest their savings aggressively, whilst the person who is more wary can use a more conservative mix.
6. How Risk Profiles Influence Investment Decisions
Risk profiles influence the type of investments, and the proportionate allocation to each type of investment that is available in a given strategy.
As an example, let’s say an investor has a balanced risk profile. For us, that would mean a target asset allocation of 60% growth assets and 40% defensive assets.
When we’re looking to construct an investment portfolio for them we’d be looking for solutions that can effectively fill those allocation buckets. So in the portion that needs to go into the growth assets bucket, we would include things like Australian and international share funds. Perhaps property funds as well. Then for the portion of the portfolio that needs to be allocated towards defensive assets, we would consider cash, term deposits, and bonds.
Risk profiles have a very strong link to the investment portfolio that would be established for you.
7. Risk profiles and Investment Time Frame
You might have an aggressive, high growth risk profile, but if you are working towards a goal that has a two or three-year time frame, then the investment mix that would ordinarily be attached to this sort of risk profile is inappropriate. An aggressive risk profile like this would typically need a time frame of seven years or more.
Conversely, a conservative investor might nevertheless choose to have their superannuation invested more aggressively, in the knowledge that these funds will be invested for perhaps 40 years or more and therefore the volatility experienced over the journey is fairly irrelevant.
The blending of risk tolerance and time frame is part of the art of good financial planning.
8. Your risk profile might change over time
It’s very common for someone’s risk profile to change over time. Often when they begin investing, the inclination is to lean more on the conservative side. This is quite sensible as it gives you an opportunity to make a start, without experiencing too much stress and worry. We frequently find that after someone has been investing for a while, they tend to go up the risk profile scale somewhat, becoming more and more tolerant of investment market volatility.
Another change that might occur relates to investment time frame. So whereas perhaps in your 30s and 40s you might be very happy being a high risk investor, when you’re a year or two out from retirement, it would be perfectly reasonable to want to see your investment mix and therefore your risk profile step down to something a little more stable.
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