Risky business: What is your risk profile?

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Risk is an inherent part of investing. No matter the asset class or the investment timeframe, there is always some degree of risk involved.

So as an individual investor how can you gauge your own appetite for taking on risk? One of the common ways for investors to get a sense of their tolerance to risk - especially those who are new to investing - is by undertaking a risk profile.

"A risk profile assesses your capacity to embrace market risk in order to achieve a higher return, and guides which assets should be included in your portfolio in what proportions," explains Chris Brycki, the founder and chief executive of robo-advice platform Stockspot.

how to assess your risk profile

"Getting your risk profile right ensures you're not taking on too much risk, which can lead to the mistake of selling when markets are down. It also ensures you're taking enough risk to reach your goals and keep up with inflation."

What goes in to working out a risk profile?

Brycki says that the trickier part is working out what your risk profile actually is. For Stockspot users that involves completing an online risk profile during the onboarding process.

"This assessment considers their past investment experience, financial goals, investment horizon, and cash flow needs to recommend the best investment strategy."

Of course, investors who are happy to go it alone can take all of these points into account when assessing their own risk profile.

Others who looking for additional guidance may want to consider the services of a financial advisor, as establishing individual risk profiles is a key part of the service that advisors can provide.

"Advisers can assist investors by asking questions about an investor's existing experience with investments, how comfortable they feel about market rises and falls, what their investment timeline is, and their investing purpose," says Sam Hunt, a private wealth adviser at Shadforth Financial Group.

"An adviser could be speaking to a young novice investor who is wanting to invest for the next 20+ years, and therefore is happy to experience significant volatility. Alternatively, they could be speaking to an experienced investor, who is more interested in capital preservation given their stage of life."

What are the different types of risk profiles?

While it's important to stress that profiles will differ from investor to investor depending on their goals and attitudes, investment risk profiles tend to be separated into a few broad categories.

Typically, this will go from conservative at one end of the spectrum, to moderate, balanced, growth and then aggressive at the other end of the spectrum.

A conservative profile generally lines up with a lower tolerance for risk. In this case an investor might lean towards a portfolio mix that favours the preservation of their money at the expense of lower growth - perhaps because their investment timeframe is shorter.

On the other hand, an investor with an aggressive risk profile may be more comfortable with a portfolio mix which skews towards assets that provide higher - though more volatile - returns (historically), because they have a longer horizon to invest over.

How can time affect your approach to risk?

Nothing is certain when it comes to investing, but a longer investment timeframe can help to compound returns and smooth out periods of volatility. That's why an investor's timeframe is likely to be an important factor when determining the level of risk they're prepared to take.

"Generally speaking if you have a shorter time horizon of less than four years, or you need to take regular dividends from your portfolio, you might be considered more conservative," Brycki says.

"Whereas if you have a long time horizon of over ten years and you don't need regular income, you might be considered an aggressive investor."

While investors should be open to adjusting their risk profiles over time, Hunt warns against chopping and changing them too regularly.

"Changing a risk profile every 12 months would lead to unnecessary trading which could have capital gains tax implications as well as additional transaction costs," he says.

"A decision on an investor's risk profile should be well considered, as it is something that should be stuck to for at least the medium term."

Which assets will suit your risk profile?

So if you're going about building an investment portfolio, how can you work out the kinds of assets that may be a better fit for your risk profile? Again, that will come down to the individual, but there's some general thinking on the subject.

Hunt uses the approach of a younger and older investor towards their superannuation as an example, as they are likely to have different investment mixes based on their risk profiles and age.

"The investor in their 20s knows they cannot access their superannuation for another 30-40 years, so they might be happy to be more exposed to growth assets such as shares, property, or private equity, which form a larger part of a more aggressive risk profile.

"An investor in their 50s or 60s might be thinking more about capital preservation as they approach retirement, meaning their risk profile would include greater exposure to cash, term deposits and bonds."

Of course, it's generally still handy to have some degree of diversity - even in the most conservative or aggressive portfolios.

"Regardless of your risk profile, our advice to clients is that all portfolios should have a mix of growth and defensive assets to provide a smoother investing journey," Brycki says.

"Diversification across lots of companies is also important to spread risk which is why we recommend ETFs since they spread your money across thousands of companies."

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Tom Watson is a senior journalist at Money magazine, and one of the hosts of the Friends With Money podcast. He's previously worked as a journalist covering everything from property and consumer banking to financial technology. Tom has a Bachelor of Communication (Journalism) from the University of Technology, Sydney.