What is your risk profile?

All investing involves risk – but some people are more comfortable with risk than others.

Risk is an essential part of investing and refers to the range of variables that affect an investment’s ability to provide the expected level of returns. This can range from market factors, the track record of the company, and the safety nets that are in place to protect investors.

Knowing how to work with risk is essential for any investor. And establishing a risk profile is the first step on this journey.

What is a risk profile?

Your risk profile basically tells you what sort of an investor you are. If you are a low-risk investor, you might prefer to follow a conservative investment strategy, investing only in regulated, well-established companies and bonds. A medium-risk investor may choose to invest in less well-established companies which have a higher chance of growth, alongside more conservative choices. And a high-risk investor will be comfortable taking on very risky investments which could either pay off handsomely or result in significant losses.

It is worth pointing out here that there is no such thing as a risk-free investment. Even government-backed bonds have failed at times. But by following a low-risk investment strategy it is possible to manage the risk of ending up with a loss-making portfolio; even if that means settling for lower returns.

How to work out your risk profile

Every individual risk profile is different, but there are three broad categories that investments can fit into. These are referred to as your risk ‘appetite’, literally the degree of risk that you are willing to stomach when making an investment.

• Conservative appetite - this prioritises safe investments and protecting your resources. A conservative investment approach combines minimal risk with reduced returns. Conservative investment portfolios tend to take a long-term perspective to investing.
• Moderate appetite - this approach seeks to find a balance between taking on higher risk in the hope of higher returns; and protecting your capital. Moderate investors are willing to tolerate increased, but not significant, risk for increased returns in the medium term
• Aggressive appetite – these investors are willing to incur some losses in the hope of getting the highest returns. They may prioritise making returns in the short term or adapting to volatility to provide significant returns in the long term

Your individual risk profile will dictate the composition of your portfolio, so learning about your risk tolerance is an essential first step for new investors.

However, it is also important to note that your risk appetite will change over time. Young investors can afford to take a higher-risk approach, as they have their whole lives to bounce back from a big loss and make more money. As young investors get older and take on more financial responsibilities, they may be less inclined to take risks with their money, moving them into the moderate risk band.

To work out your risk profile, it can be helpful to ask a few questions.

What are my investment goals?

If you are saving for your retirement, you are likely to want to take a longer-term, lower-risk approach to your money. Not many people are willing to bet their hard-earned pension savings on a high-risk investment.

If you want to diversify into new asset classes to support short-term investment goals, you may be more comfortable taking a higher-risk approach.

What is my income?

Your ability to weather risk is determined by your income and available budget. High risk investing should be supported by an established emergency fund and cash savings, so that you don’t overextend your finances. When making high risk investments, you should always ensure that you can afford to lose whatever you put in – you should never be using the family grocery budget to fund a high-risk investment.

What is my investment horizon?

How long do you intend to invest for? The answer to this question will help influence your risk profile. Short-term investors may be more comfortable pursuing a more aggressive strategy that will balance out over time; whereas long-term investors can use compound interest to boost the value of their money in the long term, meaning that they can prioritise steady returns over quick wins.

How to mitigate risk?

There are two ways in which you can minimise risk in any portfolio: diversification and compounding.

Diversifying your portfolio means selecting a combination of assets that represent the diversity of the market or the specific sectors that you are interested in investing in. This means that if one investment struggles or fails, the impact to your portfolio will be minimised.

Compounding is the act of reinvesting any interest on your investments. This allows you to accrue interest on interest, increasing your gains over time and allowing you to ride out any volatility.

Taking a calculated approach that is based on a solid understanding of the market can help you to pre-empt risk wherever possible and tailor your approach to insulate your portfolio, no matter what your risk profile may be.