Risk profiling is a crucial, but often overlooked, part of constructing an investment portfolio and it also helps eliminate emotional investment decisions. Here, Mohd Sedek highlights three types of risk measurements.
When instability occurs in the market, emotions are involved in investments. During turbulent economic times, one may be tempted to perform drastic actions on the investment portfolio, such as withdrawing investment to their fixed deposit.
An exemplary situation is when an adviser invested RM100,000 of an individual’s money and the value is reduced to RM80,000. There may be various reactions toward this RM20,000 loss, be it selling all or some of the investments, buying more of the investments, or not performing any actions at all.
Investors tend to assume that they can act rationally upon volatility or when their investment values are decreasing. However, in reality, they become highly emotional upon experiencing losses to the point of selling off investment stakes of their portfolio. Therefore, frequent updates of risk profiling are essential in order to match the investment portfolio with risk appetite, as every investor’s attitude towards risk differ from each other.
Although risk profiling is an integral part of portfolio construction, it’s a component which is often overlooked. However, by filling a risk profile, investment advisers would be able to identify the investor’s level of required return and risk in terms of capacity and tolerance. As a result, their investment objectives could be achieved.
Three Types of Risk Measurements
Risk profiling involves three types of risk measurements: namely risk capacity, the risk required, and risk tolerance.
Risk capacity a mathematical measure of the maximum level of risk which the investors could manage before it affects their financial goals. Therefore, it should be determined in the early phase of the risk profiling process, and act as a reference for the investment portfolio risk. Furthermore, risk capacity could be used during risk analysis which would determine the choice of appropriate risk responses.
Moreover, it would also manage financial risk shift in the long term. This is because it’s influenced by investors’ financial factors, such as promotion or job loss, new-born child, or health issue which leads to unpredictable medical bills.
While risk capacity indicates the maximum level of risk that investors can manage, risk required refers to the optimal level of risk managed by investors to achieve the desired level of investment return. Reaching the ideal investment return is essential to fulfil investment objectives. This shows the direct correlation of the required risk with investor’s required level of return.
Unlike risk capacity and risk required, risk tolerance is a more subjective component. This is because risk tolerance is leaning more towards an emotional representation. Nobre and Grable (2015) defined risk tolerance as the willingness to engage in risky behaviour where possible outcomes can be negative. However, risk-taking behaviours could be divided into different domains which had no correlations between them.
For example, a person who enjoys rock climbing may prefer conservative investment while retirees may prefer aggressive investment. Therefore, it could be said that the risk taken depends on the individual.
Risk tolerance could also vary by gender. Grable (2017), who reviewed financial risk tolerance in psychometric angle, proposed the investment adviser to look at risk tolerance in two different methods. The first method is to look at it as one of the inputs in the client’s overall risk profile comprising of age, investment objectives, time horizon, experience, and risk capacity. The financial adviser then evaluates these factors and determines the asset allocation.
The second method is making risk tolerance as the primary determinant of portfolio decisions, where risk tolerance acts as the mediator between a client’s risk profile and engagement in risky behaviour.
It’s recommended for investors to regularly review their investment portfolio to make sure that their investment performance is in line with the expected return and investment objectives. In the current volatile market, some investments may present a good performance at times, while there are times where their performances are vice versa. Therefore, it’s essential for investors to review their investment portfolio with advisers from time to time.
In contrast, an investment with poor performance could significantly affect the portfolio’s returns, especially if it constitutes a big part of the portfolio. By reviewing the investment portfolio, investors would be able to separate their emotions and tactical decisions from the investment processes. However, when should investors review their investment portfolio is the key question. In general, investors should review the investment portfolio with their financial advisers on a yearly basis. In addition to this, reviewing the investment portfolio should be done when investors have gone through different stages of life.
To illustrate this point, during the early stages of an investor’s career, he’d usually need a combination of liquidity and growth in their portfolio. Throughout the employment period, their risk and return preferences will reflect stable incomes and an increase in their commitments and goals. Following that, as they are approaching retirement, the investment portfolio should primarily reflect the need for income, including several stages of growth to manage the effects of inflation.
The anxiety over the decrease in investment value by more than 30 per cent is inevitable. In fact, during the times when the market faces extreme volatility, some investors choose to rely on their instinct to make investment decisions. While there may be a few extraordinary individuals who could succeed in this decision making, most individuals would commit mistakes.
Essentially, risk is a natural component of investment. However, the knowledge regarding risks associated with investment and the practice of risk profiling would assist investors in determining their comfort level and building their portfolios as well as expectations accordingly.
About the Author
Mohd Sedek joined Standard Financial Adviser Malaysia in 2014 as Head of Investment and Financial Planning, managing Corporate and HNWI investment portfolio, as well as investment research and strategy. He holds a bachelor degree in economics, master degree in Business Strategy, Leadership and Change, Islamic Financial Planner from IBFIM and a certificate in Corporate Sustainability from NYU Stern Business School. He’s currently pursuing a PhD in Economics at Universiti Malaya.
Photo by Sam Loyd on Unsplash