Understanding your risk appetite: how much is too much?
Too often investment risk is evaluated with only the asset in mind rather than taking into account whether it's actually a good fit for you, the investor.
Knowing your investment risk profile will go a long way to determining what, when, how and why you or your adviser choose certain investments in your portfolio. And it will give you a clearer picture about what to do when financial markets enter complete chaos.
Nerida Hicks, financial adviser at Bridges Personal Investment Services, says a common misunderstanding about risk profiles is that - by name - they're associated with losing money. She tells clients that the risk profile is only one factor in how an investment portfolio is constructed and there are several measures of risk.
In their simplest form, risk profiles determine your investment appetite and whether you're better suited to a growth or defensive portfolio. Taking this a little further, your risk profile might be categorised into conservative, moderate, balanced, growth or aggressive investment options. Alternatively, your risk profile can be assessed by the asset classes in which you're prepared to invest.
Charles Badenach, financial adviser and principal at Main Street Financial Solutions, says common misconceptions about risk profiles include that they remain static over time; what happened in the past is likely to happen again (recency bias); and that they can forecast future returns.
"In addressing these issues it really comes down to educating and working with clients on an ongoing basis to ensure that how their portfolio is structured is consistent with their risk profile, whilst at the same time allowing them to meet their needs and objectives," says Badenach.
That last point of meeting "needs and objectives" is vital when considering any investor's risk appetite but it's especially important for retirees as they're more exposed to what is known as "sequencing risk". For example, a retiree may withdraw from their pension account during a market downturn and this will cost more in the long-term because the account has to work harder to sustain returns and maintain pension payments.
Badenach says when you retire it's worth reassessing your risk profile and adjust your asset allocation to minimise these risks.
For more on the different types of investment risk, see our glossary.
Does COVID-19 change my risk profile?
Badenach says a major financial event such as COVID-19 shouldn't be the main catalyst for reviewing or changing your risk profile.
Hicks says changing your risk profile during a volatile time isn't wise, especially if you want to reduce your risk profile to be more conservative.
"This may impact on the long term performance of your portfolio. Sticking to your long-term plan and remaining focused on why you're invested is key in times such as COVID-19," says Hicks.
Troy Theobald, financial adviser and director of financial services at Robina Financial Solutions, also agrees and says a good financial plan or strategy accounts for market movements.
"It is essential that the strategy is in place first and that you take the time to ensure clients understand the strategy. Reminding them of this can help them find some peace of mind amid all the daily uncertainty," says Theobald.
He says it's incumbent on a financial adviser to ask the right questions and not just give you the "guided tour" of your risk profile. This would include asking how you think you would react and feel if a major financial event such as COVID-19 happened, and what would it mean for you.
"It is important to have this documented to remind them in the crises. There will be no good news on TV in any sharemarket downturn. They need to know what the strategy is when this happens not if it happens. There is a big difference in these two approaches," says Theobald.
He adds that when you consider changing your risk profile, ask yourself these three questions:
- What is the basis for the change in risk profile?
- Is there information you know and the rest of the world does not?
- If you do sell, when are you going to feel comfortable to re-enter the market?
All three advisers agree that your risk profile should be reviewed at least every six to 12 months.
"A structured approach with adequate cash buffers that quarterly re-weights the client's individual portfolio should allow them to hold their risk profile and actually benefit from market downturns," says Theobald.
What if I fit into more than one risk profile?
Badenach says this depends on what you're trying to achieve.
Let's say you're trying to buy a house within three months as well as grow an income stream to assist in retirement. An adviser might split the money and adopt separate strategies for each tranche, Badenach says.
In the current volatile investment climate, Badenach may also use a dollar cost averaging approach to gradually work a client towards their long term targeted asset allocation.
Hicks says it's more likely that a couple will have varying risk profiles rather than an individual. She says if this is the case, portfolios can be set to the individual couple's needs.
"In this instance, however, it would be explained that this may impact on the overall return and objectives of the couple in the long term," says Hicks.
"It may be the client that has a more conservative view has further explanation and education so that the overall strategy is met and a mutual risk profile is established for the good of both parties."
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