Understanding Investment Risk for Retirement Savings
Understanding investment risk and its relationship to your risk profile is important for your retirement savings so that your nest egg is diversified into asset classes and assets that are right for you. Rather than randomly putting a stake in the ground, before investing ask “What is the right allocation across these asset classes to suit my investment temperament?”
The best way to determine your investment temperament is to complete risk profile questionnaire. Good risk profiling for determining investment risk is critical to long-term success of your personal financial planning and your emotional wellbeing and if followed will increase the chance of you meeting your retirement savings goals.
How is a risk profile created?
Measuring an investor’s attitude to investment risk is part art and, through the development of some useful predicting tools, part science. A number of different profiling tools are commonly used.
Demographic profiling is often used to determine how much should be invested in income versus growth assets. It usually looks at a range of factors including time and age.
While age is important, it should never be the only criterion. All too often it has been determined that someone in their 60s must have a conservative portfolio. Yet they could be comfortable and/or need to have a significantly higher weighting in the growth assets of property and equities to meet their goals. Further, it is just as conceivable that a 20-something individual could be extremely conservative. Looking just at age, is to focus exclusively on capacity, ignoring tolerance which is how you might behave in reaction to a particular set of circumstances.
A psychometric profile questionnaire looks instead at risk tolerance – how well you cope with market ups and downs. The questions are based on your behavior in response to specific situations. In developing the test, data has been collected from the test results of tens of thousands of respondents, and the results form a continuum, which in turn provide a guide to your likely behaviour. The results of your own test give you a score, which is then compared with the historical data and placed on the continuum.
The profile derived from your test results can be used to put you into a category to predict how you will react under certain circumstances and to determine the level of risk with which you will be comfortable. In identifying your ‘comfort band’ the profile will guide you to a decision on what’s right for you. This information is then aligned with what you need to earn from your investments (this is capacity) and you can then make a decision whether to stay within that comfort band or deliberately stepping outside it in order to achieve your goals.
When investing retirement savings, we all want a nice steady climb in our assets. In a diversified portfolio, with a percentage in property and equities, the reality is that risk and return are linked and the value of your portfolio will go up and it will go down.
Sometimes the path a steady increment in value but sometimes it’s rocky and uncomfortable. An investment risk profile is very useful as it helps to determine your reaction to the inevitable adverse times in investment markets.
What is the difference between risk capacity and risk tolerance?
Risk capacity and risk tolerance are two quite different things.
- Risk capacity is what you need to earn to achieve your goals.
- Risk tolerance is your emotional reaction to likely volatility.
What is an investment risk profile?
An investment risk profile is an analysis of your attitudes to money, and in particular your attitude to the volatility of the investment market. It’s a way of converting a set of your responses into quantifiable data which you (or your financial planner) can then use in identifying the level of investment risk with which you are comfortable.
A comprehensive risk profile will prove invaluable because from the results you (or your financial adviser) can establish an asset allocation.
Some risk profiling measures capacity, others measure tolerance – and both are important for your financial plan.
Can other factors affect my investment risk profile?
Your investment risk tolerance can be affected by life’s events, both past and present. At any single point in time, say after a marriage break-up, loss of a job, or as you age, your risk profile may change. At such times you would be well advised to complete another survey to determine the effect of these changes. You can then ascertain whether you need to alter your asset allocation.
A psychometric test only measures risk tolerance. However, thorough financial planning establishes your overall capacity using a series of questions relating to your goals and aspirations. This information is combined with your tolerance to determine the asset allocation and consequently return you might achieve.
Why should I do a risk profile?
Doing a risk profile and determining your risk tolerance is critical to the long-term success of your retirement savings investment portfolio. Why? Some examples follow:
- If you are conservative in temperament, investing with a high proportion in growth assets (property and equities) will result in much discomfort under particular conditions. This discomfort results in anxiety so that you just want to “fix” it and the most obvious way to do that is to cash in your investments. History is riddled with investors doing just this. Given that your investments are well diversified in quality products, then to exit your portfolio during a market downturn will only crystallize your losses and hurt your chance of achieving long-term financial success.
- If you’re more aggressive and are placed in conservative investments like cash or fixed interest (note, that some fixed-interest is very high-risk), you will never be satisfied with the returns and may begin to chase unnecessarily risky returns. Then, if your risky investment turns bad, you may miss the target you are aiming for.
Both scenarios will result in a disgruntled investor. And if you get it wrong by choosing the wrong asset allocation, you may not achieve your goals.
How do I choose a risk profile?
There are a number of places on the internet where you can go to obtain a risk profile. Alternatively a good financial planner can assist you.
Once you have completed the test, the results will fall within a normally distributed bell curve, with most people’s results congregating around the mean. You then need to interpret the results to determine what's the best asset allocation for your retirement savings.
Your profile should then be linked to an appropriate asset allocation.
What do I do with my investment risk profile information?
Your investment risk tolerance score might indicate that your emotional ability to tolerate the ups and downs of investment markets is average, and that based upon this score alone it might be recommended that you should have a portfolio of approximately 50–60% invested in the growth assets of property and equities, and the balance in the income assets of cash and fixed interest.
Sometimes information from the individual’s risk profile might highlight that the return the investor expects to attain exceeds the rate reasonably likely to be earned in the wider market.
For example, if an investor wants three times the return from bank deposits and if the return from bank deposits is 7%, then the investor expects a 21% pre-tax return. This is possible for a high-growth diversified portfolio during some periods but is completely unrealistic over an extended period of time.
Historical data might determine that the market return will fall short of this investor’s expectations 100% of the time. Knowing that you will never be satisfied with expected returns is powerful information as it will help you rethink what you expect from your investments and that in turn may mean a re-evaluation of your goals.
When should I consider adopting more risk?
If you won’t reach your goals without taking more investment risk, then you could consider taking more risk with your money in order to obtain the necessary return. So rather than having 40-50% of your investments in cash and fixed interest, to meet your goals it might be necessary to have 20% of it invested in these asset classes with the balance in the growth assets which historically return more over time.
If you find this prospect unappealing, you are not alone. When people are asked about how much risk they want to take and they indicate none, it’s hardly surprising, because it is rather like asking people how much pain they would like inflicted when being injected. But if you were advised that by putting up with a little pain, you could reach your financial goals and enjoy life more, then you might respond, “I will accept some pain – but I want a reasonable level of certainty that the pain will reduce over the long term.”
Am I taking too much risk with my retirement savings?
Risk and return is inextricably linked and we all want to maximise risk whilst minimising our returns.
You may have identified through planning that you want or need to take more risk, which is acceptable because you will understand the reason for volatility in your portfolio when it occurs. What you want to avoid, however, is taking more risk with your money than you think you are. This situation is not at all uncommon and some examples might include:
- Investments in just one or two assets, or one or two asset classes.
- Owning shares in private companies. There can be a variety of difficulties with these because they are not openly traded so there may not be a purchaser for your shares.
- Fixed interest investments where the company has a poor credit rating, which may lead to loss of capital and income if the company is bankrupted.
- Syndicated property investments where the value realised at the time of sale is often a fraction of the cost to the investor. Often these investments are shown in reports at the original purchase price. The returns may be guaranteed for a period of time but when this time expires they are frequently much less.
- Inappropriate asset allocation – i.e. the asset allocation is incorrectly weighted for the investor. If there is too much invested into fixed interest the investments may not produce the returns you require.
- Or, if you invest in too high a percentage of growth assets for your risk profile then you may take fright in times of volatility and withdraw your money, thereby consolidating a loss from which it is hard to recover, either emotionally or financially.
- Holding poor quality investments, i.e. companies with few prospects or with high debt, or companies that are poorly managed.
What to look for in terms of retirement savings
Holding a portfolio that appropriately diversified in terms of:
a) Country – it is wise to have your money spread across different countries to help shield you from any downturn in a local market.
b) Asset classes – have some in each of the four major asset classes of cash, fixed interest, property and equities
c) Individual assets – ensure your investments are widely diversified across many different investments within the asset classes.
d) Investments that will keep pace with inflation.
Long Term Retirement Savings
Psychometric testing is a powerful tool and the results of this investment tolerance testing should guide you towards an appropriate asset allocation for your retirement savings.
Combine the results of your risk tolerance with your risk capacity, and you have the ideal tools for making decisions about long-term financial planning.
This information is general in nature. It is for education purposes and not for basing your financial decisions - for that you should talk to a financial planning expert who will look at all your circumstances.
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