wealtharticles-profile_your_risk

Profile Your Risk Right.

How nice it would be if we could just have the ‘returns’ and disregard the ‘risk’. Never mind the kind of risk - Market Risk, Inflation Risk, Business Risk, Interest Rate Risk, Country Risk, Currency Risk or Credit Risk - just leave it to the experts to sort it out. Unfortunately, the truth is that we cannot ignore ‘Risks’. You would get the ‘Returns’ when your investment has made a profit. In the same way, the ‘Loss’ also belongs to you when your investment drops below its capital outlay. Profit and Loss from your investments are two sides of the same coin.

There is no escaping from risk. ‘Risk’ does not appear all of a sudden when you have suffered an investment loss. When you have made a profit, you have already taken some risk, whether you know about it or not. Even if you do not invest your money, you would be taking a risk - inflation risk!

Hence, if you want an assurance that your investment plan would work because it looks good on the outside, you should take a good look inside too. Know your own risk profile!

How can a risk profiler help me?
The risk profiler is neither a document to be submitted merely for the sake of compliance to the regulatory bodies, nor is it a tool for your financial adviser to protect himself in case you suffer losses from your investment on a later date. The risk profiler guides the investor through a series of questions and based on a scoring system, it arrives at a number to determine the investor’s risk profile. The risk profile of an investor ranges from being ‘very aggressive’ to ‘very conservative’.

A typical risk profiler would include questions on:
- Age
- Investment time horizon
- Reaction to losses
- Expected rate of return

While some have criticized that it is overly simplistic, I find it useful in highlighting to my clients the following:
-Real possibility of loss in an investment
-Time is needed for any investment
-Objective or purpose behind the investment
-Expectation from the investment

In addition to the above points, to know what the clients cannot afford to lose is vital at the start of financial planning. Also, “Begin with the end in mind”, i.e., to make our money work harder for us, we need to defer our spending in order to accumulate for a specific goal.

What they didn’t tell you about risk
With the introduction, can we say that the risk profiler is really effective in serving its purpose? There are 4 kinds of risk appetites of people and they are, (1) Punter; (2) Smart Investor; (3) Hard Investor; (4) Occasional Punter.

The Punter - High perceived risk appetite but low in risk capacity
The ‘Punter’ thinks he can take risks and invests in risky instruments or portfolios comprising a high percentage of even riskier products, expecting potentially higher returns. Upon market declines, he sees his investments dropping to a level which he cannot accept. In fact, he cannot believe that this is actually happening to him. He is initially convinced that he can withstand a temporary ‘paper-loss’ which is inevitable in any investment. But as the market value declines and amidst very negative market sentiments, he withdraws from the investment, unfortunately at a point of a substantial loss.

The Smart Investor - High perceived risk appetite and high in risk capacity
The ‘Smart Investor’, like everyone else, wants a higher rate of return on his investments. The difference is that he can actually stomach the significant loss on his investments. There can be many reasons for this.

Some of the reasons are:
1.He has set aside adequate funds, thereby reducing the chance of having to liquidate his investments in an emergency situation.
2.He has a long-term investment horizon and can extend his holding period if necessary.
3.He has diversified his investments and is not dependent on any one particular investment for income.
4.He has planned well and for fulfillment of immediate goals, he has moved some of his holdings to lower risk portfolios.

The Hard Saver - Low perceived risk appetite and low risk capacity
The Hard Saver is afraid of losing his hard-earned savings and does not like to see his savings drop in value due to market forces.

He tends to put his money in conservative instruments like time deposits, endowment policies, guaranteed products, government bonds and properties. He prefers to see his money grow steadily. He is likely to be more concerned with short-term stability rather than to chase higher returns. The downside is that he needs to save a lot more since the growth of his investments is generally low.

The Occasional Punter - Low perceived risk appetite but high in risk capacity
The occasional punter has a higher ability to take risk than he thinks.

Although the occasional punter feels that he is risk averse, he can occasionally take higher risk. As various investment opportunities are offered to him, he reasons that the investments may be viable. It is not uncommon to hear stories of conservative or long-term investors who have taken their chance on risky instruments which they did not really understand.

A Qualified Financial Adviser Representative can help
The four examples highlighted above shows the importance of correctly matching one’s risk capacity to his investment choices. An error made in understanding the risk doe not necessary spell disaster all the time, but it is surely something one hopes to avoid. The benefits that can be brought in by a financial adviser in these cases are of tremendous value to the investor.

Managing Risk
An aggressive investor may choose an investment portfolio that comprises a higher percentage of high-risk instruments such as equities, commodities, whereas a conservative investor would prefer to invest more in ‘safer’ instruments like bonds and money-market instruments.

As the saying goes “high risks, high returns”. If we all wish to have high returns, we have to take more risk. However, never risk more than what is necessary. In other words, do not take unnecessary risk.

Modern Portfolio Theory suggests reducing risk through diversification. You can diversify your investments in different asset classes and spread the risk across various industries, countries, regions, and even by investing over different time periods.

A good way of diversifying your investments would be to invest in a portfolio of unit trusts that is well balanced. Unit trusts are diversified financial instruments. Unit trusts are managed by fund managers who invest in a portfolio of equities, bonds or other financial instruments such as equities and low-risk instruments such as bonds, an adviser can tailor-make a well-balanced and diversified portfolio for the investor.

Changing Risk
Once the risk profile of an investor has been determined, it should be reviewed periodically, especially after a change in the circumstances and needs of the investor.

The ‘Punter’ group may change the risk profile as over a period of time he understands his own reactions to losses better. Unfortunately, it is usually after he has suffered some loss.

Another possible scenario is when a person gets older and his investment horizon comes closer. On the other hand, avoid following the ‘herd instinct’. Do not change your risk appetite and jump onto the bandwagon just because others have made some profits in a particular investment. Do consult your adviser for professional advice. Your risk profile should not change with the changes in market sentiment.

Conclusion
Investment is about making your money work harder for you. Nobody goes into investment intending to lose their hard-earned money.

The key to successful investing is to know your investment objectives and risk profile. There is a strong correlation between understanding your risk profile and the likelihood of you staying committed to your investment plan.

Once you are clear with the investment objectives, time horizon, expected growth as well as your ability to stomach loss of your investment, you can then select the appropriate investments that you know you can stick to despite worsening market conditions.

If you had started your investment with a plan, knowing your own risk profile would help you stay on course and arrive at your desired destination.

By iFast Financial Pte Lts
An abstract from the magazine iFast Insight, August 2009 - January 2010.