What’s the right risk profile for you? Key questions to consider

Think carefully about your ability to handle high volatility.

 

Working out the appropriate level of risk for an investment portfolio has become a far more sophisticated process in recent years. Where advisers would once have asked clients just to tick a box marked “adventurous” or “cautious”, says Jason Hollands of Tilney Bestinvest, investors today are faced with a vast array of product choices designed to meet different risk levels, as well as a set of detailed questions assessing their risk tolerance. From actively managed funds to government bonds and cash, suitability is the watchword. 

 

If you’re unsure of your investment needs, it’s always wise to seek professional help. But here are a few of the most important questions to think about when deciding on the right risk profile for your investments.

 

For very long-term investors – someone in their 30s putting money away for retirement, for example – higher allocations to riskier assets like stocks will be more suitable than for short-term savers. The reason, as Fidelity’s Tom Stevenson told City A.M. earlier this year, is that over long time horizons, the number of years in which equities outperform cash and bonds gets close to 100 per cent. As observers of markets this year will know, there’s likely to be plenty of bumps along the way – the FTSE 100 is now down almost 5.3 per cent year-to-date, having been close to all-time highs mere months ago. 

 

But the longer you’re saving for, the less these price swings will matter. Of course, the opposite is true for short-term savers. Even someone who considers themselves an adventurous investor should take a cautious approach if they’re saving for a house deposit in a few years’ time, says Thomas Diaper of Plutus Wealth, since there’s a chance that their investments will fall in value just before the money is needed.

 

The next thing to think about, according to Danny Cox of Hargreaves Lansdown, is whether you require a specific rate of return to meet your investment goals. It sounds obvious, but a low-risk portfolio is unlikely to be able to provide returns of between 5 and 10 per cent per annum. And if your investment goals require relatively rapid capital growth over a number of years, Cox says, there’s no alternative to taking on  slightly higher risk. Again, the inverse holds for an investor not trying to hit an ambitious target. 

 

This one splits into two related questions. The first is psychological: is a sharp bout of market volatility likely to have you in cold sweats, or are you made of stronger stuff? In one sense, risk profiles are extremely personal and subjective, says Diaper. Some are happy to open themselves up to the possibility of sharp falls in the value of their portfolios, while others would find the high volatility levels of a riskier portfolio too stressful, preferring to keep their money in government bonds or cash. The majority of us are somewhere in between. Companies like Oxford Risk offer psychometric testing to help establish where you fall on the scale. 

 

But Diaper points out that sometimes the results of these tests contradict an investor’s stated objectives, and it’s difficult to separate psychological risk aversion from the second, related issue of an investor’s financial capacity to handle volatility. Think of it as a personal stress test – how would a sudden fall in the value of your investments affect your financial life? The tendency of risk assets like stocks to go up in the long-run should allow those with deep pockets to weather any market storms, even allowing them to use dips as a buying opportunity. But others could be wiped out by re-run of the 2008 financial crisis. If you lack the capacity to absorb large losses, says Cox, a lower risk profile will be more suitable. This is especially true if you may need to access your money in times of difficulty.

 

Which brings us onto the final point: how likely is it that you’ll need to change tack at short notice? “A key point in risk profiling is to think about what might happen if you need to liquidate investments in a tight timescale,” says Hollands. Some riskier investments, shares in small companies for example, can be relatively illiquid – it’s difficult to sell them at short notice for a good price, and doing so will often incur a transaction cost whatever the asset.

 

And given the tendency of high-risk portfolios to go up and down in value, moving up the risk scale could be unwise if you might need to liquidate. But it’s not a point that only applies to high-risk profiles – products like cash Isas often come with fixed term limits, so it’s always worth thinking about access.