Sensible investment and wealth management requires a
balance between your risk profile and investment portfolio
volatility.
Both of these factors can be combined to make up your
investment policy and investment philosophy.
It's important to understand that your risk profile is
really comprised of two aspects: your risk attitude and
your risk capacity. Risk attitude is the true measure of
your personal comfort with risk. Are you willing to risk a
less favourable outcome whilst attempting to achieve a more
favourable one? (risk vs return).
Risk capacity is your ability to sustain a less favourable
outcome without jeopardising your original goals and
objectives. Risk capacity is affected by factors such as
time horizon (allowing you time to recover from an adverse
return) and total wealth (allowing you to go through a
decline in account value and still maintain your desired
spending).
The two areas are as important as each other and it is
vital that you take both into account when making important
investment decisions. For example, if your risk attitude
means that you could sustain a 25% market decline without
any impact on your goals, the appropriate portfolio may
contain 60-80% equities.
However, if your risk attitude measure indicates that any
decline in excess of 10% would cause you cold sweats and
sleepless nights, then the 60-80% equity portfolio is
clearly not the right approach. Instead, you should be
invested into a portfolio with a lower percentage of
equities.
So, how can you address your full risk profile?
There are two keys:
First, you must obtain a true measure of your risk attitude.
This can be obtained by using a comprehensive risk
profiling system. You won't be able to achieve this by
second guessing it yourself, as it's highly unlikely you'll
know enough for the assessment to be successful. You should
speak to your Financial Adviser/Planner and ask them what
they're using. One of the most comprehensive tools is
provided by FinaMetrica. Their assessment contains 25
questions and your score (1-100) will be compared against
the whole pool of those who have completed the
questionnaire.
You should then make sure you interpret the score correctly
and are able to act upon the information effectively.
Secondly, you should work through a process of financial
planning to determine your true goals and objectives. This
step is CRUCIAL as without it, how will you know what your
tolerance is for risk capacity (i.e. how will you know how
much loss you can absorb without it affecting the
likelihood of you achieving your goals).
Once you know how much downside you can tolerate, you can
then determine what the appropriate investment policy
should be, using risk attitude as a constraint. This should
lead you towards deciding what percentage of equities you
want in your portfolio.
The alternative approach is that you remain invested in a
higher percentage of equities, but prepare yourself that
you may need to adjust your goals (retire later, spend
less, spend more, etc) if the portfolio value falls too
much. Of course, you may reach your goals sooner if the
higher risk portfolio grows at a faster rate than the lower
risk portfolio.
The Financial Tips Bottom Line
When you break it all down, it's more than likely that
you're trying to achieve your goals and objectives in some
form. And most people would rather try and reach their
goals with the minimum amount of risk (yes, note I said
some people - there'll always be the risk takers amongst
us).
ACTION POINT
The subject of investment risk should not be
underestimated. If all you've done up to now is assess your
risk on a scale of 1-10 (and believe me, this is VERY
common), maybe it's time to take a more comprehensive
approach. After all, it's only going to improve your
understanding of your own risk tolerance and how much risk
you can afford to take.
----------------------------------------------------
Ray Prince is an Independent Financial Planner with
Rutherford Wilkinson plc, and helps UK Resident Doctors and
Dentists get the best deals on mortgages, protection and
investments, as well as helping them achieve their
financial objectives. Just visit
http://www.medicaldentalfs.com to get your free retirement
planning guide. Rutherford Wilkinson plc is authorised and
regulated by the Financial Services Authority.
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