Understand Your Own Risk Profile

One of the hardest parts of my job, other than finding prospective clients burdened with loads of excess cash to invest of course, is trying to actually understand individual attitudes towards risk. The reason it is so difficult is because most people don’t really understand their own risk profile to begin with, and thus communicating it to a financial advisor often becomes the useless exercise of coming up with a number between one and ten.
I have had so many trainees under me come back with a financial profile after an initial meeting and ask me for help putting together an investment allocation with very little more than “he’s a three” to guide me along. Most people answer this question by starting at five and then adding or subtracting one or two points based on some gut feeling as to whether they are above or below average in taking on the normal risks available in life.
This general approach is very wrong for several reasons. We should normally break risk down into two separate areas. There is the ability to take risk, and then there is the appetite for risk. Most people will have a declining ability to take on risk as they get older, because they have less and less time for recovering from a loss or drawdown. Of course some people’s wealth compounds to a point where their ability grows more quickly than their future cash flow needs, and this is in fact the end goal of proper financial planning. While it sounds simple in theory, implementation is far from it.
Appetite for risk is more personal and less a function of age, years to retirement, life expectancy, or even overall wealth. Some people got rich by taking large risks in business and do things like sky-dive for fun, but when it comes to the cash they earned they will only be comfortable with fixed deposits. Others may have taken a very boring approach to their career, maybe as an accountant or something similar, and yet thrive off of short-term speculating in their free time. Many very successful futures traders in history started off as farmers hedging their crops, and then found out they had a knack for “the game”.
When it comes to understanding your own risk profile, look back at long term historical performance charts of the various asset classes and think about how you would handle it if you had invested at the absolute worst time. Also look for “blow-ups” in the same asset class, since some assets can go to zero while others will not. This is risk realised, and is how you should think when considering both ability and appetite with regards to risk.
Most assume higher risk automatically means higher realised return. In reality it simply means higher potential return, yet coupled with either higher potential loss or higher probability for a loss. If you formulate your financial plan with “I need to earn ‘x’ percent per annum” but use averages, your real life return is sure to be drastically different. Only in hindsight can we tell which it will be, so make sure that if the risk is realised that the consequences to your overall net worth will not be disastrous.
When it comes to deciding on the actual risks to take, you always should err on the side of caution. If you find yourself with a high appetite for risk but little ability to tolerate the potential losses of timing it wrong, you should avoid the investment being considered. If you have a lower appetite for risk than you could realistically handle, you are likely leaving potential returns on the table, but if this helps you sleep at night then so be it. Don’t let anyone talk you into taking risks you aren’t comfortable with.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK Pension Transfers. He can be reached at david.m@faramond.com. Faramond UK is regulated by the FCA and provides advice on pensions and taxation. Views expressed here are his own.