The world of finance and investments is notorious for its extensive use of jargon. With a goal of enhancing financial literacy and making the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we address a term that is extremely important to know when it comes to every financial and investment decision you make: “risk profile.” Put simply, your risk profile is an evaluation of your willingness to assume risk when it comes to your investments. Knowing your risk profile is vital to crafting your investment portfolio, as it is the main factor that influences your portfolio allocation. To determine your risk profile, a financial advisor will have you complete a risk questionnaire that evaluates the three components a risk profile comprises:
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- Risk tolerance: Your ability to stomach the market ups and downs.
- Risk need: How much risk you need to take on in order to achieve your desired investment return.
- Risk capacity: How much investment risk (or loss) you can afford to take.
Although risk questionnaires vary from advisor to advisor, all such questionnaires generally involve a series of questions with each answer assigned a certain number of points to be added up at the end of the evaluation to provide an overall risk score. Ranges for risk scores vary by questionnaire, but lower scores typically denote a lower risk tolerance, and higher scores signify a higher risk tolerance. Your point total determines your risk profile by showing how conservative or how aggressive you are with your investment decisions, and your portfolio allocation will be based on this profile.
An additional component to keep in mind when crafting your investment portfolio is your time horizon, meaning the time frame for when you want or will need to use the funds you are investing. A shorter time horizon, typically one to five years, means you will need to be more conservative in your investment strategy and invest in funds that will not fluctuate as much with the market. Likewise, a longer time horizon means, barring additional financial needs and responsibilities, you have the flexibility to assume more risk in your investments because your investments have more time to bounce back given a market correction.
From a behavioral finance view, your risk profile tends to differ as you age and depends on the type and purpose of your account. For example, with retirement accounts, younger, long-term investors tend to have a higher risk tolerance because they know they do not plan to use that money for years down the road, and their accounts will have ample time to rebound from any losses and enjoy new gains via a high-risk, high-reward strategy. In the same vein, older, short-term investors nearing retirement tend to see their risk profiles trend in the conservative direction with a lower risk tolerance as retirement approaches because they know they will soon depend on their retirement savings for income and therefore cannot risk experiencing a major correction and potential losses.
In terms of portfolio allocations, equities are riskier investment vehicles, while bonds are considered a low-risk investment option. If your risk profile shows you are an aggressive investor, your advisor will allocate your investments accordingly, based on a 90/10 or 80/20 model, for example, meaning that 80-90% of your portfolio holds riskier equity positions like individual stocks, mutual funds, and exchange-traded funds (ETFs), with the remaining 10-20% holding lower-risk positions like bonds or money market funds. If your risk profile shows you are a more conservative investor, your investments will be allocated based on a lower-risk model, such as a 40/60 allocation, meaning 40% of your portfolio holds higher-risk investments with the remaining 60% holding more conservative, lower-risk investments.
Overall, the risk assumed in your portfolio is directly tied to your risk profile, making it of the utmost importance that your risk profile remains up-to-date and accurately aligns with your current financial life and risk capacity. The innate tendency of one’s risk profile to change over time because of major life events – for example, getting older and nearing retirement, buying a house, having a child, sending a child to college, facing emergency home repairs or costly medical expenses, etc. – validates the need to revisit your risk profile and overall financial needs on an annual basis to apply needed adjustments to your accounts.
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