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Risk management plays a significant role in investing. Proper risk management should lead to portfolio construction that is based on the investor’s unique personal profile.
What is your Risk Profile?
Risk management plays a significant role in investing. Proper risk management should lead to portfolio construction that is based on the investor’s unique personal profile.
When a person’s investment portfolio is not in line with their risk profile, they are more likely to make mistakes that will negatively affect their financial goals.
Every investor, no matter their stage in life, has their own risk profile. But what is a risk profile? This is an evaluation that is made up of the following:
Let us investigate these areas of risk in more detail.
Risk Capacity
Risk Capacity is the amount of risk a person CAN assume. This has nothing to do with thoughts or feelings about risk but is a more measurable answer that is revealed through financial planning. Risk capacity is measured using the following criteria:
In the financial planning world, this is also called goal-based planning. This process leads planners to discover what an individual has and what they need to determine their risk capacity. Below is an example of two different people with different capacities for risk.
Person 1: John Smith
John has a high capacity for risk because he has a long-time horizon and low income needs relative to assets.
Person 2: Betty Burton
Betty has a low capacity for risk because she has a short time horizon and high income needs relative to asset levels.
Risk Attitude/Perception
While risk capacity measures how much risk a person CAN take, risk attitude is a measure of how much risk a person WANTS to take. Risk attitude is more difficult to measure as it is more of a feeling than quantitative data like time horizon or income needs.
Everyone has a different attitude towards risk, and it is usually best determined through conversations and questionnaires. Typically, these questions throw out hypothetical scenarios to measure how you would react.
Example: If the market were to fall 10% would you:
A risk attitude establishes the upper limit on the amount of risk a person is willing to accept.
The problem with measuring risk attitude is where the word “perception” comes into play, in that every person perceives risk differently at different points in time. The reality is that risk attitude is a moving target.
This stems from many of the known behavioral biases humans develop around finances. Biases like:
This moving target can be seen in how people react during both bull and bear markets. Typically, when markets continue to move up or down, people’s perception of risk changes as well. Their risk attitude is the same, but how they perceive it is not.
Therefore, managing one’s risk attitude must be done both upfront and continually, like the financial planning process.
Conclusion
Risk capacity determines how much risk a client can afford to take, or needs to take, to achieve goals.
Risk attitude establishes the upper limit on the amount of acceptable risk.
Risk perception monitors how a person’s attitude changes towards risk in any given situation.
All three of these must be used together when building a risk profile. This risk profile should then be used to govern how a portfolio is invested.
At Blue Bell Wealth Management, we work closely with our clients to understand their unique risk profile. We then use this to build a customized portfolio and monitor it on an ongoing basis. Contact us if you need help in determining your risk profile.
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