Have you ever taken a risk quiz? These quizzes are designed to measure your risk tolerance, but generally not provide a full risk profile.
If you have taken a risk quiz, what was the result? Was it a single score that was then used to suggest a certain allocation of cash, bonds, and stocks for your investment portfolio? Did it give you more confidence about reaching your goals?
Identifying your risk tolerance is important, but it is just one part of a thorough risk profile. A thorough risk profile will provide insight into not only your risk tolerance, but also your risk required and risk capacity characteristics.
Are those terms unfamiliar? Here’s an illustration:
John and Sue (a fictional couple) like their current lifestyle. They want to have the same lifestyle when they retire. They are saving toward that goal.
John and Sue want an investment strategy that they can tolerate – one that doesn’t keep them awake at night with worry that they will lose their savings. This is their risk tolerance.
They could put all of their savings under their mattress. They would have 100% confidence that they would not lose a penny due to an investment that drops in value. However, their savings would have less buying power each year due to inflation. In order to fulfill their lifestyle goal, they could 1) save more, or 2) move the savings from under the mattress into an investment to increase the value of the savings over time. If saving more is not possible, then investing their savings to keep up with inflation is a risk they need to take. It is the risk required to meet their goals.
When selecting investments, John and Sue need to also consider risk capacity. They want an investment strategy that will help their savings grow, but one that isn’t riskier than they need. For example, investing 20% of their savings in stocks may be enough to meet their goals. If so, then there is no need to take on the additional risk of investing more than the 20% in stocks.
A thorough risk assessment addresses all of these risk characteristics. It will help John and Sue find their “sweet spot” – where their risk required, risk capacity, and risk tolerance converge. They can use this information when evaluating the options and trade-offs of saving and investing to reach their goals.
What is your risk profile?
- How much risk do you need to take to meet your goals (can you simply stash your savings under your mattress)?
- What type of investment strategy will help you reach your goals with the least risk of loss?
- At what level of risk will you still be able to sleep at night?
Your risk profile impacts your choices. A clear understanding of your risk profile equips you to make informed choices about saving, choosing investments, and reaching your goals.
A complete risk profile is one of the foundation pieces for developing an adaptable and sustainable financial plan for our clients. Please contact me for more information about how your risk profile fits into your comprehensive financial plan.