Your risk profile is something we mention a lot when looking at investments and other key financial decisions. But what has an impact on your risk profile?
Investing naturally comes with some level of risk and values will rise and fall over time. However, the amount of volatility experienced varies hugely. Typically, the greater the level of risk and volatility you take on, the higher the potential returns, but there is a change of a greater fall in value. For some, the potential returns of a higher risk profile will outweigh the drawbacks, whilst others will prefer the relative stability of lower risk investments, even if potential returns are reduced.
It’s important to keep in mind that all investments involve some risk. But you also need to look at the long-term picture where volatility is considered. Over the years, stock markets have experienced significant dips, which can be a cause for concern for investors. However, historically, markets have recovered to deliver returns over the long term.
There are five key factors to consider when weighing up your risk profile:
1. Your goals
The first area to think about is what you’re investing for. Having a clear goal in mind, allows you to build an investment portfolio that suits you.
What you’re investing for is likely to have a significant impact on how you feel about risk. Let’s say you’re investing to pay for a child’s education, security may be a priority for you and investments with a relatively low risk may be more attractive because of this. In contrast, if you’re investing to enhance your lifestyle in retirement, but you know you already have the assets to be comfortable, you may decide to increase exposure to volatility.
2. Investment time frame
This one links directly to what your goals are; when do you plan to access your initial investment and the returns it’s hopefully generated?
As a general rule of thumb, you shouldn’t invest if your time frame is less than five years. This gives you an opportunity to ride out dips in the market and recover from potential downturns. In turn, if your time frame is longer, you’re in a better position to take on more risk when you take a long-term view. Investing for retirement is a good example of when a long time frame may mean a higher risk profile is appropriate. When you first start saving for retirement, it’s likely to be a milestone that’s decades away. As a result, short-term volatility should have little impact when you focus on the end goal.
3. Other assets
Financial decisions shouldn’t be made in isolation. They should look at your overall financial plan and the other assets you have. This will influence your risk profile too.
For example, if you hold a significant amount in cash and other low-risk assets, you may decide to take a higher risk with new investments. It’s important to keep in mind here that not all your investments should be the same in terms of risk. Diversifying and holding a range of investment assets, with various risk profiles, can help smooth out market volatility and limit potential losses.
4. Capacity for loss
No one wants to think about losing money when they invest. However, it’s an important consideration to make. If your investments were to perform poorly and decrease in value, how would this impact your lifestyle?
You shouldn’t invest capital that you can’t afford to lose. However, there’s more to it than that. If your investments were to fall, would it devastate your future plans? Or would it simply mean that some small adjustments would need to be made to ensure your lifestyle was sustainable over the long term?
5. Overall attitude to risk
Whilst the above four factors are influential, your overall feelings about risk are too. You should feel comfortable with all the financial decisions you make, including the level of risk taken when investing.
It’s natural to worry about potential losses when investing and if you think you’re being too conservative, taking some time to understand how investment markets operate over the long term can help. On the flip side, an aggressive approach to investing isn’t always appropriate even if you’re comfortable with it. Working with a financial adviser can help you reconcile your feelings on investment risk with your financial position.
Regularly reviewing your risk profile
Remember, your risk profile can change. The level of risk you were willing to take in your early 20s when you likely had fewer responsibilities, is probably very different to the risk profile you had after you were paying a mortgage or had a family. As financial security improves or you approach retirement, the level of risk you’re willing and able to take will change again.
As part of your annual financial review, your risk profile should be one of the key considerations that’s discussed. It’s also an area to review following big life events, such as marriage, divorce or starting a family, and when your financial position changes significantly.
If you’d like to discuss your risk profile and how this should be reflected in financial decisions, please get in touch.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.