Why assessing your own risk level can be risky business

Investing isn't easy, and it always involves a level of risk. Determining just how much risk you want to take with your investments is an important part of the process.

Low-risk investments include asset classes such as bonds and cash, while higher-risk investments include assets such as international shares. And within asset classes, investment risk can vary. An emerging technology stock is likely to have a higher risk level (and perhaps a higher prospect for growth) than an established large company with more modest growth prospects.

It's prudent to take a diversified portfolio approach to combine the right mix of low-risk and high-risk investments. This is simply a form of risk management, which is particularly important when markets are volatile.

Why your risk profile matters

When you seek advice from an "expert", the first step is typically some form of risk assessment to determine what mix of investments or asset classes might be most appropriate. The answers from your risk assessment help create a risk profile that can inform whether you should consider a low- or high-risk investment strategy. This process and outcome are important for your portfolio's performance over time.

For example, a typical "balanced" portfolio for someone who wants a measure of growth potential while still protecting their downside from market losses might have a 60/40 split, meaning 60% of their investments are in growth assets and 40% in defensive assets.

Can you assess your own risk profile and corresponding investment portfolio strategy? Yes, but it's harder than you think, and the cost of getting it wrong can be high, as you may find yourself with too much or too little exposure to growth assets.

What are the risks of DIY?

You need to know the right questions to ask and the right answers to consider to make the process and output meaningful. Generally, risk assessments will test your risk appetite (how much risk you want to take), your risk capacity (how much risk you can afford to take) and your investment horizon (how long you're likely to be investing).

There are assessments in the market that ask three questions to provide a recommendation (probably too few) and some that ask 33 (probably more than needed due to the law of diminishing returns on analysis). Around 10-12 questions should be sufficient to assess the three main areas of interest.

You need to know how to process the answers correctly. Typically, algorithms are used to triangulate your answers and produce a "score" of sorts from low risk to high risk based on your answers.

But the questions can have varying levels of importance in your final score. If you're doing it yourself, how do you weight each question and compare answers? What if you answer one question with a high-risk tilt but another with a low-risk tilt? What's more important: investment time horizon or desire for capital preservation? A good assessment will balance these dynamics in determining a recommendation and risk profile, showing any inconsistencies or matters that a person should consider based on their answers, when appropriate. Which leads to ...

You need an effective "triage" process that checks for inconsistencies in your answers. If you answer one question by saying you are happy with very high-risk investments but answer another by saying that capital preservation is very important, then it's important to check that you understand what you're asking for and why.

Importantly, it can lead to you investing in a way that is not actually appropriate for your situation. A well-constructed risk assessment will have these "checks and balances" embedded into the process.

Don't risk the result

Understanding how you feel about risk and how it relates to your investments is important - your risk profile should form the foundation of your long-term investment strategy. And it shouldn't be a set-and-forget exercise - you should review your risk profile at least once a year, or whenever your life circumstances change significantly.

Bought a property, or lost your job? These things can and should be factored into your investment strategy because they're likely to affect your day-to-day financial position, and thus might affect your investment strategy.

Online investment services often provide a free assessment if you want to get a sanity check on your risk profile. If you're using a free tool, do take a look at the people behind the service and consider whether the questions make sense, the recommendation seems prudent and you understand the outcome.

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