Every investor has a different risk tolerance with regard to their investment selections. A risk profile is a broad view of an individual’s risk tolerance. A risk profile can also refer to potential threats to an organization. However, our use of the term indicates an individual’s specific tolerance to financial risk.
Risk Profile Defined
A risk profile is primarily used to select and determine the proper asset allocation for an investor’s portfolio. Essentially, an investor’s risk profile helps identify the level of risk an investor is open to dealing with. An investor’s willingness to take on risk refers to their risk aversion.
For example, an investor may rather maintain the value of their portfolio. If they’re willing to forgo potential capital appreciation, they’re likely risk-averse. On the other hand, perhaps an investor seeks high returns. If they can tolerate market volatility, then they may be willing to take on more risk.
Often, investors evaluate their ability to take on risk by reviewing their assets. An individual with many assets but few liabilities may take on more risk. On the other hand, if an investor has a lot of liabilities and few assets, they may be more risk-averse. For example, if an investor has a retirement fund, emergency savings, no mortgage, and other investments, they may be willing to take on more risk so they can potentially reap greater rewards.
However, an investor’s willingness and ability don’t always match. Just because an investor has a substantial amount of assets and very few liabilities doesn’t mean they are willing to take on risk. They may prefer to maintain the value of their accounts and play it safe.
Risk Profile Considerations
You can create a risk profile in several ways. Investors often complete a risk profile questionnaire. They receive a profile score based on the answers they provide. Some questionnaire topics include age, major life changes, income, and investment comfort level.
In addition to financial questions, a questionnaire may inquire how you handle potential losses. For example, a New York Life profile asks, “Due to a general market correction, one of your investments loses 14% of its value a short time after you buy it. What do you do?”
You could choose to sell this investment to avoid more loss or hold onto it and recuperate your loss. You may even decide to buy more stock since it is now selling at a lower price. While there is no right or wrong answer, you need to decide what’s best for you.
Your risk profile questionnaire is typically used by a a set of financial advisors (or a robo-advisors) to help you design a well-diversified portfolio. Because an investor’s level of risk correlates to the asset allocation selected, it’s important that both align.
Types of Risk Profiles
There are three main categories of risk profiles. Each speaks to the level of risk an investor is comfortable undertaking. However, there are different levels within each profile that account for variables. It may be helpful to review the overall outline of the profile that most aligns with your desired risk.
This means you want minimal volatility. Your ideal investments may offer protection with some kind of return. If you have a conservative risk profile, you may want to choose investments such as CDs or money market accounts where you will see very little volatility. Generally, your time horizon is low. Therefore, you’re unwilling to take on unnecessary risks.
This is for people who want to earn a moderate to high return but don’t want to take on too much risk. If you’re a moderate investor you may choose a balanced portfolio strategy and have a moderate time horizon.
An aggressive portfolio seeks the highest return possible. An investor may have a longer time horizon and may be willing to stomach market volatility in many different economic conditions. Aggressive investors are usually experienced investors who understand the inner workings of the market and economy. They are not scared to invest in start-ups that may yield a high return. Some young investors may take more of an aggressive approach since they have a longer time horizon.
The Bottom Line
Your investment strategy should be a combination of what you’re comfortable with contributing as well as what you’re willing to accept in return. If the idea of losing any money is scary to you, it’s likely you have a conservative risk profile. If you believe in trying to reach the highest return possible – even if it means you could lose money – you’ve got a more aggressive investment strategy.
Ideally, your risk profile should be fluid. It may change based several factors including your salary, disposable income, and age. If you’re early in your career and don’t have a lot of extra cash or assets, you may have a somewhat moderate risk profile. As you earn more, you might become more aggressive. However, as you age and get closer to retirement, you may become more conservative.
- Managing an investment portfolio requires thorough research, which can be time-consuming. Keeping up with the markets also requires background knowledge, and it may be easier for someone with access to reports, financial statements, analytics data and advanced financial modeling software. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- If you’re low on cash but willing to take the risk on earning big with strategic investments, consider hiring a robo-advisor to help manage your account. Many have no or low opening balance minimums. They also tend to charge lower fees than other types of money managers. Despite the more affordable price point, some services still provide working sessions with human advisors.
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