So like most financial advisers today, we try to clarify what ‘risk’ means – and this is usually as much to do with you as it is to do with the nature of the investments and markets you invest in.
Risk is a function of prices going up and down and also of your attitudes, needs and circumstances. Put more succinctly, risk is ‘in here’ as well as ‘out there’.
What is a risk profile?
The end product of discussions and questionnaires on the subject of risk is usually called a ‘risk profile’. It is the document that we, as your advisers, will use as the basis for any savings or investment recommendations we make. It may incorporate the output from a discussion and questionnaire, but will also include your adviser’s assessment of your circumstances and needs. Often it will include a short description of the kind of pattern of risk and return you are prepared to accept.
The risk profile is used to determine how much of your capital can be allocated to different types of investment, so you can think of it as the basis of ‘risk management’. Today, financial advisers generally consider a risk profile should have three quite different components:
Tolerance of risk. This is what you feel about risk, especially your feelings about losing money, and is usually quite easy for you to express. It is also easy to discover where on the ‘risk spectrum’ you are by completing a questionnaire or in a discussion. These are sometimes described as ‘psychometric’, which simply means they are aimed at measuring your attitudes, so indirect questions are often used. The output from such a questionnaire is usually a score on a simple numerical scale.
Need for risk. This relates directly to your aims. For example, if you have an ambitious target for early retirement, you may need to generate a high return from your savings in order to have enough capital to generate your target income. In this case you would have to take high levels of risk to achieve what you want. After discussing this issue with us, you may decide to lower your target in order to reduce the level of risk you need to take.
Capacity for risk. This relates to your circumstances. For example, if you are retired, you cannot replace any capital you lose with income from work, so your capacity for risk is likely to be lower than that of someone who is in employment. We are duty bound to consider especially your capacity for loss, in other words to evaluate what the consequences of any loss would be for you. If a loss would cause you severe hardship, we may allocate you a risk profile below the level derived from your questionnaire responses.
We create a risk profile for every new client, and will also ‘refresh’ existing clients’ risk profiles when their circumstances change, to ensure that our recommendations are still appropriate. Creating a risk profile cannot prevent you from suffering loss. But it can ensure that you understand why you are taking on a certain level of risk, and may ensure that if market prices fall, your losses are within a range you can cope with, both practically and emotionally.