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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

Investing is all about taking chances, but how much risk should you take on? That's where risk profiling comes in.

Advisers use this nifty process to figure out just the right amount of risk for you. It's all about balancing what you need, what you can handle, and how much uncertainty you're comfortable with in your investment journey.

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 about figuring out how you feel about taking risks in your investments. Wondering how it's done? It boils down to three key factors:

  1. Risk required. The amount of risk necessary to achieve your investment goals.
  2. Risk capacity. How much investment risk or potential loss you can afford.
  3. Risk tolerance. Your comfort level with taking risks in investments.

When you chat with a financial planner, you'll dive into questions about your finances, goals, and how long you plan to invest. It's like taking a personality quiz for your money - understanding what you want to achieve and when.

This helps shape a risk profile that's just right for you.

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 along with real-life hypothetical scenarios to help you understand:

  • Conservative. 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.
    Brian, 65, retired in Melbourne: Prefers a safe portfolio with 80% bonds and 20% stocks. Brian says, "I need stability over high returns.
  • Moderately conservative. 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.
    Sarah, 45, manager in Sydney: Balances her portfolio with 60% in bonds and 40% in stocks. Sarah shares, "I'm cautious but open to some growth.
  • Balanced. 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.
    Jack, 35, Entrepreneur in Brisbane: Goes for an even split, 50% stocks and 50% bonds. Jack believes, "It's all about striking the right balance."
  • Moderately aggressive. 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.
    Mia, 28, Software Developer in Perth: Leans towards growth with 70% in stocks and 30% in bonds. Mia explains, "I'm young; I can handle some market swings for better gains."
  • Aggressive. 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.
    Liam, 22, Graduate Student in Adelaide: Focuses heavily on stocks with 90% in his portfolio. Liam's motto is, "I'm all about long-term growth and high returns."

Finder survey: How many Australians know what their risk profile is?

I don't know what that is28.59%
Source: Finder survey by Pure Profile of 1004 Australians, December 2023

What questions are included in a risk-profile quiz?

Curious about what a risk-profile quiz looks like? Here's a snapshot:

  1. Life stage: Whether you're a carefree young adult, a family person juggling kids and a mortgage, or nearing retirement, your stage in life is key.
  2. Investment savvy: Are you a newbie, somewhat knowledgeable, or a market guru?
  3. Access to investments: When will you need your cash back? In two years, a 5-7 year horizon, or are you in for the long haul?
  4. Investment goals: Seeking steady returns, okay with ups and downs, or chasing high, albeit risky, returns?
  5. Reaction to market changes: If your investment drops, would you sell, hold, or buy more?
  6. Risk vs. reward: Which portfolio's potential gains and losses align with your comfort zone?

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.

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:

  1. Growth Assets. These are investments that have the potential to provide higher returns but that also come with a higher level of short-term risk. Think shares and property. They offer the chance for higher returns but come with more short-term risk.
  2. Defensive Assets. Defensive assets usually have little risk of suffering a loss but also provide lower returns than growth assets. These are your safer bets like cash and fixed-interest investments, usually offering lower returns but less risk.

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.

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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.

Remember: 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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