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How to choose the right product

Lesson 2 of 7

How to work out your risk profile

Your risk profile is a measure of how much risk you can take on and how willing you are to accept those risks.

A common misconception is that a risk profile is determined solely by age. Some schools of thought assume that the younger you are, the more comfortable you are taking higher risks. Perhaps because you have more time to recoup any significant financial losses.

Others claim that the older you are, the more experience and therefore confidence you’d have when taking on risk.

While age certainly can be a contributing factor, there are several other things that affect your risk profile. These include where you choose to invest your capital and how much of it you’re willing to risk.

How you handle money earmarked for retirement might be different from how you treat money set aside for trading activity. In this lesson, we’ll explore three risk profiles and why it’s important to know which you belong to.

The importance of risk profiles

Knowing your risk profile could help you determine how you access the markets; from the products you trade to the stocks you invest in and everything in between.

Consider your financial goal. Do you want to save up to renovate your family home? Are you looking to make a little extra spending money before a big vacation?

With that in mind, let’s look at three ways you can make money from the market and which risk profile they may suit best.

Interest

A graphic of a bag of money and a clock, representing savings earning interest.

Interest is commonly associated with savings accounts but can also be earned on mutual funds, bonds and you could even earn interest on cash not yet earmarked for an investment in some brokerage accounts. You can contact local banks or look online to discover what options are available to you.

Earning money through interest is considered stable and more predictable, whether your rate is fixed, compounded or linked to inflation. The appeal is that you’ll know upfront what interest you can expect to earn on your savings or investment, and there’s less likelihood of losing your entire capital.

Earning interest on an investment carries very little risk. However, should inflation rise above your interest rate, the value of your investment will steadily lose buying power over time.


Dividends

A graphic of money combined with a bar graph depicting how you can earn money with dividends.

Dividends are a portion of a company’s profits that gets returned to shareholders. In an ideal world, you’d be able to invest in companies that issue dividends that increase above inflation every year.

However, dividends are issued at the company’s discretion and are often tied to the company’s quarterly performance. That means they can be reduced or not paid out at all.

Dividends are also linked to an institution’s share price. This is because when a company announces a surprise dividend, the share price can sometimes rise because there’s more demand for the shares.

However, it could also fall as demand can sometimes decrease following a payout. This means your initial capital can decrease in value – even when you receive dividends.

Your return is potentially better than when you’re earning interest, but the investment is riskier. There’s no guarantee that a company you’ve invested in will pay dividends. You may also experience a capital loss depending on the company’s performance. This means investing for dividend income is considered medium risk.

Price movement

A graphic of a candlestick graph with two arrows indicating price movement in the market as a way to earn money.

When you buy an asset like a share, you’re hoping that you can sell it later at a higher price than you paid. This is investing for price movement. To take advantage of this, you’d need to purchase the asset itself, or use a leveraged product to take a position on the underlying market.

When you buy an asset that’s increasing in value, you make a profit. However, there are no guarantees that the assets you choose will appreciate. When an asset you’re invested in decreases in value, you lose money. With the benefit of time, you could withstand that loss.

If you open a leveraged position in the market, you could buy or short sell different financial instruments such as CFDs. Trading with the aim of taking advantage of price movements is considered a high-risk strategy.

Taking leveraged positions in the market takes it to the next level and is one of the biggest risks you can take with your money. Whichever you choose is likely closely tied to how much time you have and which product you choose.

It’s possible to use a blend of interest, dividends and price movement. An exchange-traded fund (ETF) with bonds or cash as its base could work very well. You might want to choose one with some shares that give you access to both dividends and price movements.

If you’re an investor who prefers to focus more on price movement, your time horizon could stretch into decades. Here you can invest in shares to generate a profit over time. You can also receive dividends along the way.

By contrast, traders interested in price movements can have investment horizons as short as a few seconds. As you can see, risk isn’t always just about how much time you have.

Did you know?

Does the thought of losing even just a small portion of your investment seem intolerable or painful? You may be risk averse.

This means that you’re not as comfortable taking on higher risk, even if it could result in greater rewards. If this is the case, you might want to stick to mostly lower risk products and focus on earning interest.

You could try some medium risk activities, such as investing in shares to potentially profit off of dividends and selling some or all of your holdings when the stock’s price rises. However, there is still the risk that the stock price could fall and that dividends might not be paid out.

If you’re risk averse, you may want to avoid leveraged products until you’re better equipped to handle the associated risks.

A risk profile for every need

You may have noticed that any one person could have many different risk profiles at once, based on their goals.

A retiree may have some money they don’t need for another decade or two. They could also venture into high-risk territory with a leveraged trading strategy or an individual share portfolio, all while keeping a portion of their capital in a high-interest savings account.

Combining risk profiles will be dictated by what you need your different investments to do.

Homework

One way you can check if you’re in the right risk profile is to take a ‘sleep test’. Ask yourself the following questions:

  • Does closing your trading platform for the day make you feel anxious or like you’re missing out?
  • Do you feel threatened whenever the market moves against you?
  • Do you struggle to sleep when you hold positions overnight?
  • Have you ever woken up in the middle of the night, just to check on a chart?

If you answered yes to any of the above questions, it might be time to rethink your strategy. When your investments or trades keep you awake at night, you’re probably in the wrong risk profile. Often, it means you’ve taken on more risk than you can afford.

You could reduce your risk by closing some leveraged trades and sticking to products within a lower profile.

Low-, medium- and high-risk profiles

Your individual risk profile is an important part of how you interact with the markets. It’s also unique to you, which means you should determine which one matches your circumstances.

While you may fall into more than one profile at any given time, your profiles themselves may include a combination of higher and lower risk financial instruments.

Generally, these profiles fall into three main categories: low risk, medium risk and high risk.

Let’s dive into the different profiles and how you might participate in the market within each.

Risk appetite broken down into three main profiles: low, medium and high.

Low risk

A low-risk profile is generally going to consist of savings products and bonds.

Did you know?

When a government, bank or corporation wants to raise money, they may issue a bond. This is a type of security that acts as a loan for the issuer and an investment for you, the purchaser.

The issuer promises to return your initial investment in full at the date of maturity. This is just the agreed upon length of time until you’ll be paid out.

Bonds typically pay you interest on your investment annually in the form of a coupon. This is the term used for the type of interest you earn on a bond. Sometimes, you can even convert your bond into shares after it’s matured.

By investing in a bond, you’re loaning money to the issuing institution, essentially purchasing their debt. Should you choose to make this part of your wealth-building strategy, remember that they don’t always pay out in full.

There’s a chance that only a percentage of your initial investment will be returned. However, you’ll often earn a higher interest rate than if you just put the money in a savings account.

Savings products pay predictable and regular interest that can either be reinvested or spent, depending on the need. While they may be low risk, your money could devalue.

For example, say you have a savings account with a fixed interest rate of 3% per annum and inflation is at 5% in any given year. The cash in that account will buy you 2% less at the end of the year, even with the interest earned.

Using low-risk strategies like these also tends to make a profit slower than if you purchased individual shares or traded using leveraged products.

Let’s check your understanding.

Question

Say you’re saving for the down payment on a new car. You’ve sold your old one and will need a new vehicle by next year so that you can get to and from work without relying on public transport.

You choose to place your money in a savings account with your local bank. They offer a 2% per annum interest rate, and you choose to add $15,000 to your account.

The cost of the new car you’re planning to buy is $15,800.

If you withdraw your funds after a year, will you be able to afford the car of your choice?

  • a Yes
  • b No

Correct

Incorrect

First, you’ll need to calculate your interest. So, 2% of $15,000, which equals $300. Then, add the interest to your original investment. If you combine $300 and $15,000, your available funds equal to $15,300. This is $500 less than your ideal car’s cost, so you’d need to postpone purchasing your car.
Reveal answer

Medium risk

Here, we’re moving up the risk curve. A portfolio for a medium-risk profile could include individual shares or even collective investments like ETFs, investment portfolios and interest-bearing products.

Some people use a mix of both low-risk products and higher risk shares, essentially creating a medium-risk profile.

You might start with 80% in a savings account and only 20% in shares, changing that ratio as you become comfortable with taking on more risk.

Question

You’ve just received a sum of money from an inheritance and you’re looking for ways you can try to grow it in the markets.

You decide to put some aside for a special holiday you want to go on in the next two years. You’re willing to postpone the trip if necessary to take advantage of higher returns.

Because of your longer, more flexible timeline, you can take on some risk. Which of the following financial products would suit your profile?

  • a Leveraged products
  • b An investment portfolio including bonds and shares
  • c Both of the above

Correct

Incorrect

This profile typically falls into the medium-risk category. In this instance, you’d most likely select an investment portfolio that includes a mix of low-, medium- and high-risk bonds and shares. While you do have time on your side, your investments may be volatile and devalue instead. The bonds in your portfolio could help reduce some of that volatility. Again, these products don’t guarantee a profit, and the issuer might be unable to return your full investment.
Reveal answer

High risk

In a high-risk profile, you might want to trade products with higher liquidity, as well as build an investment portfolio. You could add derivative products such as CFDs and other leveraged products.

The money you set aside for a high-risk portfolio should always be money you can afford to lose. This is because the markets can be volatile and there’s always the risk that you’ll lose some or all of your capital.

There are also different charges involved in these leveraged products, which could eat into any profits you might make.

Here’s a handy way you can manage how much money you’ll need to use different high-risk financial instruments:

Homework

Use the table below to investigate different leveraged products, how they work and what they cost. Complete the details about each instrument. The first one has been done for you.

Product How does it work? What extra costs may apply?
CFDs

A leveraged product used to take a position on the underlying market’s price movements.

You’ll take a position based on whether you think that price will rise or fall.

Some CFDs have a spread wrapped around their buy and sell prices, while others will incur a commission.

  • Commissions
  • Live price data feeds for certain shares
  • Currency conversion charges
  • Overnight funding charges
Company shares
Futures

Remember, some leveraged products like CFDs could see you losing more than your initial outlay, so you’ll need to prepare for that financial drawdown as well.

By maintaining a solid understanding of which profile (or profiles) your wealth-building activities fall into, you’ll be able to better understand your risk appetite and therefore which products are right for you.

Lesson summary

  • Your risk profile is determined by your financial goals and risk appetite, not just by your age
  • There are three main risk profiles you might fall into: low, medium and high
  • Depending on which risk profile you fall into, you may focus on earning interest and dividends or trying to make a profit from price movements in the market
  • If the thought of losing even a small amount of your money in the markets causes you discomfort, you may be risk averse
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