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What is risk profiling and how does it work?
Your risk profile is a crucial factor when deciding where your money will be invested
Risk profiling is an important part of the financial planning process. When you meet with a financial planner to discuss your investment plans, he or she will assess your tolerance for risk and then use that information to help you make important investment decisions.
So what does risk profiling involve and what impact does it have on where you invest your money? Read on to find out.
What is risk profiling?
Risk profiling is the process of calculating your attitude to risk. When you meet with a financial planner to receive investment advice, you’ll need to answer a range of questions about your current financial situation, your investment goals and investment time frames – in other words, what are you hoping to achieve with your investments and over what time period? This assessment process commonly takes the form of a risk-profile questionnaire or quiz.
Your financial planner will use the information you provide in this questionnaire to determine your risk profile. Your risk profile takes into account a number of factors, including:
Your current financial situation
What are your debts and other ongoing expenses? How much income do you earn? How much money do you have to invest and how much financial risk can you afford to take?
Your investment goals
What are you hoping to achieve with your investments? Are you saving towards a particular goal, for example funding your retirement, or simply aiming to build wealth?
Your investment time frame
How long do you have to achieve your goals? Do you need to maximise returns in a short time frame or are you happy to play a longer game? What risk is required for you to reach your investment goals in the desired time frame?
Your general attitude to risk
Are you willing to adopt a riskier investment strategy in return for potentially higher rewards, or would you feel more comfortable if your portfolio was geared more towards guaranteed consistent returns?
The aim of risk profiling in financial planning is to not only determine the financial risk you have the capacity to take, but also the level of risk you are willing to take.
What are the different risk profiles?
Your risk profile outlines the level of investment risk you are willing to accept. Generally speaking, the greater the risk with an investment, the greater the potential returns. However, opting for riskier investments also means you need to accept the potential of losing money.
When you fill out a risk profile quiz – you can see some sample risk-profile quiz questions below – your answers will be graded with a score. Your total score at the end of the quiz will be tallied so that you can be classified into a particular investment style.
The names given to risk profiles vary, but profiles tend to fall into one of the following categories:
You want stable, reliable growth and/or a high level of income. You are only willing to accept minimal losses and may have a short-term investment time frame.
You want reasonably stable growth and/or a moderate income and are willing to accept a moderate level of risk. Your investment term is a few years or more.
You’re looking for a diversified portfolio that contains a balance of security and the potential for growth. You’re willing to accept a certain level of volatility and will typically be prepared to invest for five years or longer.
You want to invest in a broad range of asset classes but with a greater focus on growth rather than income. You’re willing to accept volatility in the value of your investments in return for potentially higher growth, and you could be looking to invest for up to 10 years.
Long-term capital growth is your main focus. You’re willing to accept substantial fluctuations in value in the knowledge that you will be able to access the highest possible returns in 10 years or more.
How does my risk profile affect my investment decisions?
How you perceive risks has a big impact on which investments are best suited to you. Generally speaking, investments can be split into two categories:
These are investments that have the potential to provide higher returns but that also come with a higher level of short-term risk. Shares and property are two examples of growth assets.
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Defensive assets usually have little risk of suffering a loss but also provide lower returns than growth assets. Cash and fixed-interest investments fall into this category.
The money you invest will be allocated to a mix of defensive and growth assets, with the exact asset allocation chosen based on your risk profile. So what types of investments match my risk profile? If your risk profile is conservative, your portfolio will be skewed towards investments that provide safe, guaranteed returns, such as cash and term deposits. In fact, defensive assets could make up 75% or even more of your investment portfolio.
On the other hand, if you’re classified as an aggressive investor, your portfolio will contain a much larger allocation of high risk/reward investments, for example Australian and international shares.
If your risk profile is balanced, your investment portfolio will include a combination of growth and defensive assets, perhaps skewed slightly towards either asset class depending on your personal circumstances.
Risk profiling and robo advisers
It’s not just traditional financial planners and advisers that use risk profiling; you will often also need to fill out a risk profiling questionnaire when you sign up for a robo-advice service.
When you open an account with a robo adviser, you will need to answer a few simple questions about your investment amount, your investment goals and your tolerance for risk. These answers will determine your risk profile, and you’ll then be assigned an investment portfolio with an asset allocation designed to suit your appetite for risk.
For example, if you sign up for an account with Raiz Invest (previously Acorns Australia), you’ll be asked to provide details about your financial situation, investment goals and time frame. Based on your answers, you are then matched with one of five portfolios of exchange-traded funds (ETFs) designed to match different levels of risk and return: Conservative, Moderately Conservative, Moderate, Moderately Aggressive and Aggressive.
What questions are included in a risk-profile quiz?
Are you looking for a risk-profile template or an example of a risk-profiling quiz? Below is a list of questions you may expect to find in a risk-profile questionnaire.
What stage of life are you at?
For example, you could be young, single and have few financial burdens, and be looking to generate long-term wealth. Alternatively, you could be a young family coping with a mortgage and raising two kids, or a mature person preparing to leave the workforce and wanting to ensure a comfortable retirement.
How much do you know about investing and investment matters?
Are you a complete novice, somewhat familiar with the share market and other investments, or an experienced investor?
How long before you would need to access the money you invest?
You may need to access the funds you invest within two years, have a mid-range goal of five to seven years, or be looking for a long-term strategy of ten or more years.
What are your investment goals?
Do you want guaranteed and reliable returns, are you happy to accept some variability in returns, or are you willing to accept unstable but potentially higher returns?
How would you respond in a specific investment scenario?
For example, if you had an investment portfolio of $50,000 and market conditions caused it to drop to $40,000 during a short period, how would you respond? Would you sell all or some of your investments, hold your position or invest further?
How much potential loss are you prepared to accept in return for potential gains?
For example, Portfolio A has a maximum potential gain of $15,000 and a maximum potential loss of $2,000, while Portfolio B has a maximum potential gain of $25,000 and a maximum potential loss of $10,000 – which would you be more likely to choose?
Your financial planner will use the answers you provide to determine your risk profile, and then match you with an investment portfolio that matches that profile.
However, remember that your financial-risk capacity and your attitude to risk will change over time, so don’t assume that once you’ve chosen an investment portfolio based on your risk profile you can simply “set and forget”. Review your risk tolerance and your investment portfolio with your financial planner regularly to make sure your investments are still suitable for your needs.
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