Objectively, it’s a procedural piece of the investing process that is used by financial institutions, required by legal & regulation, to better understand the client that the institution is serving.
So what does it do? A proper risk profiling exercise should ideally help your financial advisor understand your investment needs and preferences. This allows him/her to help you achieve your goals in a more appropriate, accurate and even comfortable manner.
There are 3 main components that would affect your risk profile
1. Risk Required:
The required minimum level of return based on your goals. (mainly based on your goal; the more aggressive your goal, the more risk you need to be willing to take
2. Risk Capacity:
The maximum level of losses that you are able to afford (mainly based on your available capital; the more capital you would like to contribute to a goal, the larger your capacity).
3. Risk Willingness:
Level of risk you are willing to take on to achieve your goals (mainly based on your psychological inclination towards risk; the greater the amount of loss & uncertainty you are willing to expose to, the greater your willingness).
There are 2 main components to deriving Risk Willingness:
Certainty Effect: How much assurance you want in terms of attaining gains
Loss Aversion: The maximum loss you are willing to take in return for potential return
When these aspects of risk overlap, it becomes easier to identify situations where they might be in conflict.
Say you wanna achieve a million dollars in 10 years, but with only 100k worth of contributions you can put in, you might find you need to be willing to take an incredibly high risk to achieve it (but in this case, it’s actually near impossible, sorry sweetie).
Sometimes you need to scale down your goals you set out, or bite the bullet and dedicate more cash for your goal, or maybe (easier said than done) convince yourself it’s okay to be faced with uncertainty and temporary loss. Confusing? I think so too. So let’s explain it with life.
Kinda like riding a bicycle as a kid for the first time. There’s a couple things you need to take into account.
Risk required: you need to deep dive into something you’ve never done before. So you are required to take on the risk of falling down and getting a boo boo.
Risk capacity: it’s kinda like, how many teeth you can lose if you fall down? If you do it when you’re still with your milk teeth, you know you can go all out, because you’ll get new teeth. But if you already outgrew your milk teeth, then your capacity to fall and hit your face is a lot less!
Risk willingness: how much happiness you get out of potentially being able to ride free with the wind in your face. This is made up primarily of a couple factors:
✓ Certainty – the number of training wheels you use to be able to feel the wind in your face.
✗ Loss – how many times you fall before you say “screw this!”
Are the factors exhausted?
Of course, there are many other factors that come into play, which can be harder to identify, and are most malleable. Think about your dad or mum being there with you while you practice riding a bicycle. Does it encourage you to try harder? Perhaps it makes things seem easier when they’re there to catch you. Or maybe them being there stresses you out!
That’s kinda like external influences, such as your investment experience, or the presence of a financial advisor or friend who advises you. Different people may react differently to these influences. Someone who recently lost money may become scared to invest, because of the potential to lose more, but someone else may become pushed to take riskier choices in order to recover their losses.
Experience is another factor that would affect your risk profile at that point in time. After a while, you’re probably happy to go faster, to use less training wheels, to maybe even go for a ride without daddy nearby. This is your appetite for risk willingness adapting to changes in your experience and knowledge.
Of course, there’s so many other factors involved. Do you have weak bones that makes the potential for breaking something high? Are you tired and sleepy, and therefore lose balance more easily?
We often expect our financial advisors to be able to do so, to act in our best intentions, paying attention to our financial goals and risk profile at that point in time. However, this may not always be the case.
To me, some financial advisors are kinda like a lazy dad. He took you out cycling cause he actually just wanted to step out to have a smoke, or because mum forced him to do so. While he might love you, he might not be that interested in your learning process or how hard you fall.
This is akin to how some advisors can be driven by commissions. They may manipulate you to purchase products that may give them greater commissions, that may not be best aligned to your financial goals and risk profile.
While there are a lot of advisors out there who are genuinely interested in helping you, it may not always be the case, or that they have too many clients and one or two might just slip through their fingers.
So what’s the best thing?
Slowly work to know yourself better. Be active in your investments until you learn what you’re comfortable with and can operate within those margins, or have a financial advisor who knows them as well.
Ultimately, daddy can give you the push, but you’re gonna need to be the one pedaling.
Do you have questions about risk profiling? Talk to us.
Are you wondering how you can choose a great financial advisor instead of shady one, we can help you out as well.
Also check out our infographic on Risk Profiling and Asset Allocation here.