Know your own risk profile

You may have heard from an investment advisor at some point that your investment risk profile is important. Today I will cover what the term means, why it is important and what it implies.

When it comes to investing, I like to talk about five keys to success:
1. Spend less than you earn
2. Have your portfolio reflect your risk profile and timeline
3. Understand what you are invested in
4. Watch your fees
5. Stick to your long term strategy

I’ve spent a lot of time writing about the first of these (the defensive side of managing money), so in the coming weeks I’ll dig into the other three. Today will be all about #2.

I meet with a lot of people who are understandably mesmerized with the number of investment choices available to them. It’s not surprising. There are thousands of mutual funds, index funds and exchanged traded funds, never mind bonds of every colour and flavour and individual stocks from every country, industry and currency.

How is someone to sort through it all and figure out what is best for them?
The vast majority of investors simply aren’t equipped to figure this out on their own, so they seek the help of a financial professional to help them. Hopefully that financial professional conducts a review of your risk profile. This might mean a survey that you complete, or a host of questions posed asking about your level of sophistication and knowledge when it comes to investing, or your investment timelines, or how you would feel under certain circumstances, or a combination thereof.

Example question: “How would you feel if your portfolio dropped by 25% tomorrow?”

Example answer: “Ahhhhhhh!!!!!!”

This might indicate that a portfolio comprised of a single equity sector is not right for you.

The objective of the risk profiling exercise is to understand what your asset allocation should be. Asset allocation refers to the percentage of your portfolio that should be held in stocks, bonds and cash (generally). You might also hear it referenced as equities, fixed Income and cash.
Someone with long timelines, more knowledge, and a comfort level with risk will likely be directed to a portfolio more heavily weighted towards stocks/equities (meaning an ownership stake in a number of companies). Someone with shorter timelines, less knowledge and a desire to retain capital (so more risk-averse) will likely be directed to a portfolio with more bonds, GICs and cash.

Once an investor’s risk profile is determined, asset allocation is a relatively simple exercise. And the experts don’t argue much about the percentage weightings for an aggressive vs. a conservative investor.
When you hear the term ‘balanced portfolio’, this generally means a portfolio equally weighted between equities and fixed income investments. It is typically recommended for those with medium to long term timelines, some knowledge and a balanced view on growth (recognizing some capital may need to be at risk in the short-medium term in order to achieve better average long term returns).

It’s important to keep in mind though that one investor may have multiple objectives. If they have an RRSP for themselves, an RESP for their teenaged child and a TFSA Savings Account for their next car purchase, each of these portfolios requires a different assessment of their risk profile, and a different portfolio asset allocation.

Money required in the short term (say, 1-3 years) should not be exposed to any risk. This makes self-directed RESPs an interesting category for investing. Parents need to keep an eye on performance, timelines and asset allocation – and yes, it should change as children hit their teens. Dan Bortolotti, Canada’s Couch Potato investment expert and MoneySense editor has written this about RESP asset allocation:

“(18 minus your child’s age) x 10 should be the maximum percentage your RESP should hold in equities”.

While I like this idea generally, remember, understanding your own personal investment risk profile is far more important than taking an expert’s blanket opinion on asset allocation. There are as many opinions as there are products, so the more you improve your own financial literacy, the more likely you’ll know what is best for you.

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