What does risk profiling mean?

By Just Money Editor

The word ‘risk’ can instil fear into the heart of any investor. But the reality is that if you want to make a good return, that beats inflation, then you will have to take some risks with your investment capital at a stage of your life.

But how much risk should you take and at what age should you stop taking risks with your money? Before you start investing you have to determine what type of investor you are. This exercise is what the industry commonly refers to as risk profiling. “Risk profiling determines what your risk appetite is and how you psychologically averse you are to volatility,” explains Marius Fenwick (pictured), chief operating officer of Mazars.

Generally, financial institutions gauge your appetite for risk by making you fill out a questionnaire. But Fenwick doesn’t think this is accurate. “The problem is that answers usually differ three, six or even nine months afterwards. I think companies should move away from questionnaires and instead determine how much risk a client should take to get to their objective in the future. Then we can more easily determine how much equity and asset growth exposure he or she should have.”

Risk vs. reward
British-born American economist, Benjamin Graham, once wrote: “The investor’s chief problem – and even his worst enemy – is likely to be himself.” This refers to the fact that investors often let emotion get the better of them, particularly when they lose money in tough economic times. The first act is to panic and disinvest money when a stock or fund is underperforming, but this is often the wrong thing to do.

This theory has been proven by investment management firm Allan Gray. In their June quarterly commentary note, the firm points out: “In previous articles we showed that the average investor in each of the Allan Gray funds that include equities, has not achieved the return of the funds themselves; in other words they have bought and sold our funds at the wrong times...The only explanation we can find for the underperformance of investors relative to our funds is that behavioural biases (e.g. favouring recent performance over long-term performance, or reacting fearfully after a big decline) persuade them to buy and sell at the wrong times.”

“Investors who placed money in the markets in 2006 and 2007 took a huge smack in the 2008 financial crisis but they are now in positive territory again. So if you have a strategy you should stick to it. Don’t disinvest as soon as you get nervous or if the markets suddenly do badly,” advises Fenwick.

Fenwick adds: “In conservative investment funds you could lose between 2-4% of your money, in a moderate risk investment you could see a potential drop of between 10-15%, while in a high risk portfolio you could see a drop in as much as 40% if not more. But you have to realise that it’s a bumpy ride and you could always be in positive territory again. Nothing is an exact science.”

How important is your age when considering what to invest in?
The younger you are the more aggressive you can be in the equity market say the experts. The reason for this is that time is generally on your side and, historically, equities have generally been good performers over the long term. “You should always have a portion of your capital in growth assets. The problem is that the majority of South Africans retire with a shortfall and the question is do you put some money into equities to make up for that shortfall and risk some of your money or do you invest conservatively and then not make enough to live on,” says Fenwick.

How to conduct your own risk profile
Fenwick says there are three questions you need to ask yourself if you want to determine what your appetite to risk is:

1.    What objective do I want to reach and over what period?
2.    What kind of returns do I want?
3.    How much am I prepared to lose on my investment and can I accept this risk?

“After you’ve asked yourself these questions you have to adjust your exposure levels to what you are comfortable with potentially losing,” he explains.

When it comes to investing your money there are many funds and brands to choose from. According to Allan Gray, South Africa now has 39 distinct unit trust management companies offering 765 funds for individuals to choose from. If you want to invest your money overseas there are even more funds to choose from.

Fenwick advises investors to stick to known brands and fund managers. “Do not to fall for false promises. If it [the investment product] is not regulated by the Financial Services Board then walk away. Don’t go for super profits. Find out who the guarantor is and ask for proof of that. If the guarantor is not a reputable institution then the guarantee is worthless,” he adds. 

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