Last Updated on 6 July 2021 by Dan
Hello everyone! One of the biggest challenges where starting to invest is working out what level of risk is right for you – and building a investment risk profile is a key element of doing this.
This post continues our series for novice investors on things to consider when starting to invest. This builds on the last point in the “Starting to Invest” series where we looked at some of the different products on offer in the marketplace.
Today we focus on understanding your tolerance for risk, which particularly applies when going down the stocks and shares route, and how you can improve your own understanding of your personal investment risk profile.
As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter need to be right for your circumstances. We always suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.
Why do I need an investment risk profile?
The reason it’s important to have an investment risk profile is because the stock market is volatile. It can tend move up slowly (and occasionally quickly) and down very fast indeed.
The volatility is a good thing to some degree – you need a bit of it to get returns when it moves upwards. However we need to make sure we can tolerate any losses when it drops if we might need the money in the shorter term.
This point is important because when the market does drop it tends to run in parallel with an economic recession – so there a higher chance of your potentially needing the money at the lowest point if you end up in a tricky situation like losing your job.
Usually stock market downturns come from some kind of trigger event, but it can be unpredictable what that factor will be. As a result trying to time the market to sell at the right time is a bit of a fool’s game, even for the well-informed. Crashes are so much easier to predict with hindsight!
What do I need to consider as part of my investment risk profile?
There’s a few questions we need to ask ourselves:
Do I have any future financial needs?
– We need to consider time risk: Do I have any known life events (for example buying a house for providing for children) that I am reliant on these funds for and may need to drawdown on them at a particular poin?
If you do, you need to adopt a more cautious approach, as you cannot predict if the timing of that purchase will coincide with a downturn in the market.
It may be sensible to think about what you have in total and what you need for the purchase. You could then take a dual risk strategy, and carve out what you know is your minimum needed amount to put low risk investments and then any remaining in a higher amount.
How much could I afford to lose?
– We also need to consider loss-aversion: If I’m looking to draw down on my investments, what percentage of them could I lose before it begins to affect my lifestyle?
This one is really important – after all you’re investing for a purpose, no matter if it’s to have a solid financial bedrock under you for security or to save up for something in particular. So you want to be sure you’re not putting yourself in a position where you’d be relying on funds which aren’t there!
How do I work my investment risk profile?
The easiest way to understand your investment risk profile is with a simple financial risk profiling questionnaire.
Just to point out as well that if you’re engaging with a financial adviser at all, these are the kind of questions you’d hope they’d be asking you as part of their fact finding and if not, it’s a bit of a red flag.
The below are just sample to provide you with a broad idea of the kinds of questions to think about – it’s too simplistic to be used for serious purpose, but should at least provide some idea.
In the questions, I’ve focused mainly on the loss-aversion element mentioned above – you’d need to factor in the time risk element as well.
Pick the letter that best matches you and then scroll to the end to build an idea of what this may mean for you. (I’ll just stress again this is indicative, and not financial advice).
|1. Which of the following statements resonates with you most?|
|A. My investments should be completely safe; I am uncomfortable with the idea of potentially losing money.|
B. I understand there’s an element of financial risk in investing but I would like this to be a small as possible, even if it limits my gains.
C. I am comfortable taking some risk as long as the rewards are appropriate, but I could not tolerate a single large loss.
D. I am comfortable taking larger risks as long as the rewards are appropriate. I can tolerate a large loss, in knowledge that markets will usually go up again over time.
E. I am comfortable making speculative investments in higher risk companies.. I acknowledge a proportion of these may fail, but the gains from a successful investment make it worth it.
|2. The maximum percentage I would be comfortable with my portfolio value dropping in a single year is.|
|3. Of these portfolios, I would choose|
|A. 100% invested in Company X, which provides an estimated return of 1% a year and a 0% likelihood of loss. 0% invested in Company B, which provides an estimated return of 3-5% per year with a very small likelihood of incurring loss instead.|
B. 60% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 40% invested in Company B, which provides an estimated return of 3-5% per year with a very small likelihood of incurring loss instead.
C. 50% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 50% invested in Company B, which provides an estimated return of 5-7% per year with a a small to moderate likelihood of incurring loss instead.
D. 40% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 60% invested in Company B, which provides an estimated return of 10-15% per year with a moderate likelihood of incurring loss instead.
E. 10% invested in Company X, which provides an estimated return of 2% a year and a 2% likelihood of loss. 90% invested in Company B, which provides an estimated return of 30-50% per year with a reasonably high likelihood of incurring loss instead.
|4. Which of these best defines your needs with regard to the money invested?|
|A. I’m reliant on my investments for day-to-day life, and need to be able to access them at all times, and am likely to dip in and out.|
B. I can tolerate small, known periods where I can’t touch my investments, but I’ll want to use them for day to day expenses when they mature.
C. I actively make a conscious effort to leave my investments alone, but occasionally spending requirements will mean I may need to take some money for my investment pot.
D. I intend to leave my investments alone and separate from the rest of my finances, but would need access in emergencies or to fund larger purchases like a house.
E. I am likely to have little need to touch my investments on an ongoing basis.
You may have noticed that in the above we’re asking very similar questions.
The reason behind this is purely confirmatory – sometimes we view a question slightly differently if framed a different way. The quiz is therefore designed to see if you reach a consistent answer. Ideally, you’ll have probably come out with a similar letter at least on at least questions 1-3, or one letter out at most.
If that didn’t happen, it might be worth reviewing and thinking about why?
Interpreting your investment risk profile
|If you answered mostly……|
|A. These largely describe a current account type investment, and suggest you are a very cautious investor with nearly no appetite for any risk.|
B. These largely describe a mix of current accounts and bonds, and suggest you’re a moderately cautious investor.
C. This describes a mix of bonds and low volatility equities, and suggests you are a balanced investor.
D. This describes being primarily invested in more volatile equities with a small holding in bonds, and suggests you’re an moderately aggressive investor.
E. This describes being entirely invested in highly volatile equities or more speculative investments like cryptocurrency, and suggests you are a very aggressive investor.
Related posts on investment topics
If you’re thinking about what your result might mean for you, I’ve including a couple of topics that might be useful:
If you’re thinking further about what’s right balance between bonds/fixed income and equities, I’ve written in more detail about that.
I’ve written a brief descriptor to help provide understanding of some common investment products and how risky they are.
And if you want to remind yourself of the philosophy of why we think investment works long term, this one!
A lot of people do jump into investing without having considering their investment risk profile, and we think it’s something really important to have worked out before you start! So if you have any questions, please do let me know in the comments below.
And that’s it!
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