Because investing globally is a long-term strategy, understanding your personal risk profile is key to staying committed. There are two components that make up investment risk: your attitude to risk and your capacity for loss.
Taking on risk in the form of volatility is the price we pay to generate investment returns. As it’s said, ‘no risk – no reward’! If you’re a long-term investor, you probably want to maximise your gains, but at the same time, you also want to minimise the risk that your portfolio will incur losses. The way to achieve this balance is to understand your personal risk profile.
What is a risk profile?
An investment risk profile is simply a spectrum of how much risk an investor is willing to take – in terms of volatility – for any given return.
However, no two investors are the same, and people view risk differently. Where you sit on the spectrum – what your personal risk profile is – depends on two variables. The first of these is your capacity for risk, which is determined by how a potential loss might affect you financially. The second variable is based on your attitude to risk. This is driven by your personality and your perception of risk.
Together, these two elements combine to create your personal risk profile, which will help you or your financial adviser decide on the maximum amount of volatility you should accept when choosing an investment strategy.
Understanding your capacity for loss
Every investor faces a unique set of circumstances. These include how much money you have, what income you earn, and the type of assets you own. Taken together, your financial situation determines how much money you can afford to lose when investing, without it affecting your standard of living.
For example, losing R10 000 on a R100 000 investment means different things to different people. If you’re unemployed or are a young family with no other assets, you have no capacity for loss: you simply can’t afford to lose any money, at any time.
But the situation is different if you have assets and don’t require extra income or need additional savings. In this case, your financial security provides a high capacity for loss. You would be in the position where R10 000 wouldn't affect your standard of living. And that means you have the choice to take on more investment risk if you want to, without worrying about the financial impact of any potential loss.
Assessing your attitude to risk
Your attitude to risk, on the other hand, isn’t about your financial position. This aspect of risk is driven by personality, and your personal perception of risk.
People perceive risk differently. While turbulent markets and volatile asset prices are thrilling to some, others dislike volatility – it can cause them to panic. It’s this emotional reaction to investment losses that dictates your attitude to risk: meeting your financial objectives is pointless if the price you have to pay is unbearable anxiety! Establishing your attitude to risk is about finding this limit, and remaining invested within it.
Understanding your own emotional tolerance to financial uncertainty and loss is the beginning of wisdom when it comes to investing. Knowing how much volatility you can bear allows you to confidently invest into a strategy, and remain invested through tough times. And sticking to an investment strategy is crucial to financial success, as it gives compounding the time it needs to work.
Your personal risk profile in practice
It's one thing to imagine losing money. However, how you react to losses in real life can be quite different to how you thought you would feel in theory. That’s why you need to be realistic with yourself about what level of volatility you can accept when selecting your investment goal. Add to that an honest assessment of your financial situation, and you have what it takes to understand your personal risk profile.
Investing for future gains without considering the emotional impact of potential losses is a poor strategy. You’ll be the one who bears the consequences – so it’s worth spending some time getting it right. If the worst comes to pass, will you lose heart, change strategy or even sell out? Or can you invest within your own risk limits, stick to the strategy and stay the course?
Preventing financially costly decisions and keeping your investment on track is what a personal risk profile is designed to deliver. If in doubt, seek professional help by consulting a trusted financial adviser.
This article is not financial advice. Please consult with a financial adviser for financial advice.
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