I often hear people say things like, ‘I want a risk-free investment’ or ‘I have got money to invest – happy to take a small amount of risk. Usually the risk they are thinking of is losing their money because of a dud investment, but there are many other risks.
Risk has at least two meanings in the investment world, and even its common meaning of loss covers several ways that loss can happen. Furthermore, by taking action to avoid one type of risk, you may leave yourself open to – or even increase – another type of risk.
Let’s unpick it a bit more. In the investment world, ‘risk’ is often regarded as volatility. So, if you regard yourself as a ‘low-risk’ investor, you may be uncomfortable with investments like shares, which can be highly volatile. The catch 22 is the risk-return trade-off.
If you can only achieve your goals by achieving above-average long-term average returns, but you consider the investments that will provide them too risky, you will have to either set less ambitious goals, or accept a more risky asset mix. In essence, this is financial jargon for having more of your money in share-based investments.
It may seem that the simple way to avoid financial risk is to place your money in the bank, where there are no entry or exit fees and you have virtual certainty of getting it all back when you ask for it. This eliminates two kinds of risk – credit risk and market risk – but it still leaves you vulnerable to all the other risks.
The reality is that life is inherently risky. In fact, it is so risky that the only certainty we have is that we will die one day.
There’s risk in getting married, risk in having children, risk in starting a business and even risk in walking down the street. But to try to dodge risk by locking yourself in a cocoon is to pay the highest price of all – you miss everything.
The way to handle risk is to make choices about how you live your life based on the balance of probabilities. This means you combine what you know to be true with what is likely to happen. Apply this to investing for retirement, and you’d have to conclude that you will probably live past 85, and that growth investments will give the highest and most tax-effective returns. Therefore, your least risky strategy would be to have a substantial part of your assets in growth investments.
At your initial appointment with a financial adviser, one of their first tasks will be to assess your risk profile. This normally includes your risk tolerance, risk capacity and risk need.
Risk tolerance
Your risk tolerance is how comfortable you are with the behaviour of any assets you choose to invest in.
Low-risk investors are generally uncomfortable with fluctuating investments. Seeking to protect most or all of their capital, they sacrifice higher returns to achieve capital protection. Portfolios mainly consist of income assets, with little exposure to growth assets.
Medium-risk investors are generally comfortable with significant ups and downs in their investment values – they understand this is the price of long-term gains. To achieve their goals, funds are spread across the asset classes, with growth assets of 30 per cent to 60 per cent.
High-risk investors are comfortable with the volatility that comes with a long-term, growth-focused investment portfolio. This type of portfolio may consist of 80 per cent to 100 per cent growth assets. These portfolios generally suit longer time frames, due to their volatility.
An adviser will aim to get an understanding of your risk profile by asking you to complete a questionnaire, followed by an in-depth interview. The following multiple-choice questions were taken from the industry-standard questionnaire.
Q. How familiar are you with investing?
- I have no experience.
- I have very little experience. I might know the balance of my superannuation fund.
- I have a good understanding. I know how my superannuation or managed funds work and I know how my money is invested
- I am an experienced investor. For example, I am familiar with investing and take an active interest in the share market.
Q. Investments that result in higher returns over the long term generally carry more risk. The greater your risk, the greater the potential for gains and losses. Which statement applies to you?
- I prefer not to take any risk.
- I accept that in aiming for returns greater than cash I will need to take small risks.
- I accept that higher returns come with a greater risk of losing money.
- I understand that significant risk is required when seeking significantly higher returns.
Frankly, I think some of the questions are confusing. The statement ‘a greater risk of losing money’ would give most people the idea that the question means lost for good. But the reality is that the best returns come from growth investments which, by their nature, rise and fall in value. To invest in these assets, you must accept the fact that you can lose money one day and gain it the next.
To make it more confusing, I believe that your risk profile is related to your financial experience. A person who has been investing in shares since they were young usually has a vastly different risk tolerance to someone who is retiring at age 65, and whose investment experience has been limited to their own home, a bank account, and their employer superannuation. True, their superannuation may well have been invested across a range of assets, but 80 per cent of Australians are ‘unengaged’ with their superannuation, and their focus may not have been on asset allocation.
Advisers tell me that they also watch how risk tolerance may change for their clients as time passes. Someone initially assessed as a ‘moderately conservative investor’ may later have got extremely worried by market fluctuations. Another may have become much more comfortable with market fluctuations over several years of investing. And those with a time frame of less than seven years need to select less volatile investments, in case the market slumps at just the wrong time for their needs. In these, and many other cases, their financial adviser would need to reconsider their risk tolerance.
Risk capacity
Risk capacity means the resources an individual has available to handle any losses that may occur. One person may retire at 65 with no investment experience, and have just $300,000 in superannuation, little chance of future employment, and a strong likelihood that they will not receive any legacies from family members. Obviously, they have a very low capacity for risk because their ability to recover from a major financial setback is almost non-existent. Another person may be 55, in a secure, high-paying job, with a high-earning partner, and both have substantial superannuation and no debts. They would have a much greater capacity to survive any major financial challenge in the future.
I appreciate that I’ve used extreme examples here, and most people will fall somewhere in the middle. But one of the major issues to consider when you are planning for retirement is what capacity you have to handle financial setbacks.
Risk need
As I have mentioned previously, some people need to accept a higher degree of risk to achieve their financial goals; others are in such a good situation that they can afford to be as conservative as they wish. But remember, the amount you will have when you retire depends mainly on the length of time you have, and the rate of return your portfolio can achieve.
If you have ample funds, you can choose to be conservative if you wish, but your risk capacity is high, so you may well have a greater risk tolerance. If, however, your assets are insufficient to enable you to achieve your retirement goals, you will need to accept more risky assets to meet your goals – or moderate your goals.
Summing up
- There is no such thing as a risk-free investment.
- The risk-return trade-off can be summarised as: the higher the return, the higher the risk.
- You cannot eliminate all types of risk, but you can choose risks that are appropriate for your situation.
- Remember to take the probability of something happening into account when assessing risks.
- Make sure you assess your risk profile before investing.
Noel Whittaker is the author of Retirement Made Simple as well as several other books including Making Money Made Simple. You can buy Retirement Made Simple for $29.99 at noelwhittaker.com.au.
Have you had to assess your risk profile? Did it help guide you in your financial decision-making? What tips can you share with other members? Have you say in the comments section below.
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Disclaimer: All content on YourLifeChoices website is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.
