One of the crucial aspects of successful investing is understanding your risk profile. How willing are you to accept fluctuations in the value of your investments?
If you choose a ‘balanced’ profile, it generally means you are willing to take a moderate amount of risk with your investments and probably have a combination of higher risk investments, such as shares, together with lower risk investments, like Government bonds.
The problem with risk profiling is that an investor’s risk tolerance is dynamic. Interestingly, in a bull market, when asset valuations tend to be higher, investors are often more willing to take on a higher level of risk. In a bear market, however, when valuations tend to be lower and therefore asset prices less expensive, investors tend to be more risk averse. In essence, our risk tolerance tends to increase at the exact time we should be scrutinising our portfolios the most!
So, how do we get away from this way of thinking? One way is to set a savings goal and only take as much risk as is needed to reach your target. Even as markets move up and down, the overall level of risk will remain the same. That way, you are not tempted to stretch your risk tolerance just because markets are strong.
Another way to look at your risk profile is to look at age-based risk profiling.
Investors in the accumulation phase might be more willing to take on a higher degree of risk in their portfolios because of their stage in life. Generally, these investors will have a longer investment time horizon and/or earnings capacity, allowing for more time to ride out the volatility in markets.
As an investor gets closer to retirement and looks to start drawing down their accumulated funds, their risk profile is likely to become a little more conservative, simply because losses at this later stage of life are harder to recoup as there is less time available.
In the retirement phase, an investor can use an appropriate combination of both of these strategies.
With an ageing population, people are now living longer. To meet their expected lifespan, investors need to manage their accumulated pool of savings by targeting a certain level of earnings. What does this mean? For a risk adverse investor, who avoids shares and other more volatile investments, the biggest risk is that their savings run out before they do!
Investors, therefore, may need to consider holding a portion of higher risk investments in order to meet their overall retirement needs; being mindful, however, to limit that exposure to manage any market volatility.
Whatever your stage of life, it’s important to discuss these issues with your financial adviser to make sure your investment strategy reflects a risk profile that’s appropriate for your situation.