Your investment risk profile depends on factors such as your goals, age, income and how much other money you have, and why you are investing, for example, are you saving towards a home deposit or a holiday in the next 12 months, to top up your superannuation or for your children's education?
When you know the answer to these questions you can begin mapping out an investment strategy because different asset classes possess different risk and return characteristics. These issues matter because you can justify why you would invest in, say, equities and real estate investment trusts which are higher risk than fixed income (bonds) investments and cash.
When trying to determine your risk profile it is useful to look at what the actual returns and level of risk have been from managed funds in the various investment asset classes over the years. The accompanying table and graph show that the higher the longer-term average investment returns, the higher the volatility.
This means that the higher the potential investment returns an investor seeks, the greater the risk or range of returns they must be prepared to tolerate. Your individual investment risk profile will therefore determine how much of your investment capital should be allocated to each asset class.
Generally speaking, investment experts will suggest that you be allocated into one of five investment risk profiles based on your attitudes to risk and returns. It is important to note that the risk categories below are guidelines only, and some managed fund responsible entities or intermediaries, such as financial planners or brokers may adopt slightly different asset allocation ranges within the various risk profiles.
For example, some balanced investment funds may invest up to 85% of your money in equities and property. It is vital to read the fund's product disclosure statement to see what ranges within each asset class the fund may invest, depending on its mandate and targeted strategic asset allocation.
"Risk" to most people means the probability of losing some, or all, of your capital. But to investment experts risk means the likelihood of investment returns fluctuating excessively - which is why it's also called "volatility".
|Average return pa
|Highest 12-month return
|Lowest 12-month return
|Range from highest to lowest
|Australian fixed interest
One-hundred per cent (100%) of your investment is invested in cash or cash equivalents. There is next to no chance of losing any of your capital, but the trade-off is that returns will be low although very predictable in the short term. The big risk is that your investment will not match inflation.
Between 30% and 50% of your investment will be in the growth assets of equities and real estate investment trusts. There is a chance of a capital loss in any given year, but you can expect higher returns over the medium term compared with investing in cash. The investment will experience moderate levels of volatility.
Between 55% and 75% of your investment will be invested in the growth assets of equities and real estate investment trusts. There is a greater chance of a capital loss in any given year, but you can expect higher returns over the long term compared with investing in the conservative risk profile. The investment will experience moderate to high levels of volatility.
Between 75% and 90% of your investment will be invested in the growth assets of equities and real estate investment trusts. There is an even greater chance of a capital loss in any given year, but you can expect higher returns over the long term compared with investing in the balanced risk profile. The investment can experience high to very high levels of volatility.
5. High growth
Typically 90% to 100% of your investment will be invested in growth assets, such as equities and real estate investment trusts. There is a high probability of a capital loss in any given year, but you can expect higher returns over the longer term compared with investing in any of the other risk profiles. The investment can experience very high levels of volatility.
To determine how you should allocate your money across these investments and asset classes according to your investment risk profile, you should ask yourself the following questions:
Many investment professionals today advocate taking a "buckets" approach to determining a suitable investment risk profile. This means placing a certain amount of funds in the cash bucket
for living expenses that may arise within the next two years, for such items as school fees, holidays, renovations and car repairs. If you have some funds that can be locked away for five to seven years, you should consider putting these funds into the balanced or growth bucket so that returns can be optimised over this longer timeframe. Cash funds that have an intermediate purpose may be best suited to the conservative bucket.
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