Your Investment Risk Profile
Helps to determine investments that suit you!
Your investment risk profile should determine what types of investments, or asset classes, you invest in. Risk profile assessment is usually determined using check sheets.
One of the first things most financial advisers do is to administer an investment questionnaire to gauge how someone feels about losing their money.
The results of the questionnaire are used to categorize investors into groups that usually range from five to seven investment risk profiles.
These categories summarize how the investor feels about investment risk and how much downside market fluctuations can be tolerated. Also how much they expect to profit when markets are going up.
The main reason for classifying someone into a defined investment risk profile category, is because most investment advisers use asset allocation models that correspond directly with each category.
Examples of categories follow ...
This type of investor has an investment risk profile that does not tolerate significant market turmoil. The defensive investor is willing to forgo most all significant upside potential, to achieve capital protection.
They do not want to get their financial statements and see less money than they had before.
Most defensive investors want their portfolio to provide them with an inflation-adjusted income stream to pay their living expenses. They do not have time or the circumstances to recoup any losses.
The majority of their money should be held in cash. Very risky asset classes are typically avoided altogether. But because of inflation, investing defensively is not without risk. Cash usually loses real value over time because of the combined effect of taxes and inflation.
Defensive portfolios produce the highest annual income yields, but produce very little capital gain.
Moderately Defensive Investors
This type of investor has an investment risk profile that tolerates a little more risk than the defensive investor, but still is adverse to large market turmoil, and require a little more investment return
The typical investor in this category is either retired and getting their paycheck from portfolio income, soon to be retired, or has been burned by poor investment management and lost a lot of money in the past.
These investors want to be protected somewhat from large downside market fluctuations and are willing to not fully participate when the markets rally upwards.
This is achieved by having a significant exposure to fixed income securities, several different types of stocks, real estate, and commodities that track inflation.
Core equity asset classes are used, but very risky asset classes are held to a minimum.
Moderately defensive portfolios produce significant annual dividend income and produce little capital gains.
They're typically going to achieve returns a little more than taxes and inflation. When the major markets are increasing, they could realize double-digit returns.
This type of investor are in the middle-of-the-road category. The most common reason to be in this category is the desire to invest long-term for retirement or higher education funding.
They want good returns, and know they are taking some risk to get them. Their portfolio should go up less than the markets as a whole, but should also go down less when markets go down.
A moderate portfolio holds a balanced mix of most major asset classes, including conservatively-managed bond funds as well as high-risk stock funds. This category typically uses the largest number of asset classes to both reduce risk and increase profits.
They expect to lose money if the markets go down, but also expect to make money if they go up.
Moderate portfolios produce modest annual dividend income yields and a moderate amount of capital gains.
They typically achieve returns greater than taxes and inflation. When the major markets are increasing, they could easily realize double-digit returns.
Moderately Aggressive Investors
Moderately aggressive investors want to outperform the relevant market index when the markets are up, and are not too concerned being down a little more than the markets when they are down.
They take on more downside risk than the markets, but expect to be substantially ahead when markets go up. Fixed income positions are minimized and risky asset classes are fully utilized.
Most moderately aggressive investors want to accumulate a significant amount of wealth in the future, and are willing to wait a significant amount of time for the rewards - and to recoup short-term losses.
More emphasis is put on making money than preventing the loss of money.
Moderately aggressive portfolios produce little annual dividend income and a high amount of capital gains. They're typically going to achieve long-term returns far greater than taxes and inflation.
Aggressive investors want to substantially outperform the markets and are exposed to much more risk than the markets. They could easily lose up to 40% of their portfolio value in a few months, and it may take years to recoup these losses.
These investors typically hold mostly growth, small-cap, and sector mutual funds or stocks. The purpose of any cash held is to take advantage of perceived buying opportunities.
Most aggressive investors either want to accumulate substantial wealth in the future, have enough income from other sources to fund their living expenses, and/or have time recoup losses.
They know they would lose a very high percentage of their money if the markets go down, but also expect to profit greatly if they go up. Most all emphasis is put on making money.
Aggressive portfolios produce the little-to-no annual dividend income and produce large capital gains.
They typically achieve long-term returns far greater than taxes and inflation. When the major markets are increasing, they expect to realize large double-digit returns.
The discussion has described a range of investor types in terms of their investment risk profiles ranging from defensive to aggressive.
The profiles range from those requiring stable dividend income with little or no capital gain to those with little or no dividend and large capital gain expectations.
Value investors minimize their risk by building in a margin of safety in their investments. This places them further down the continuum than they would otherwise would be.
Where are you on the investment risk profile continuum? Your position should determine the dividend income and capital gain expectations from your investment portfolio.
But in the final analysis, it comes down to whether the mix of investments you hold allows you to sleep well at night, irregardless of the state of the stock market.
The recent global financial crisis would have been a good test of your risk tolerance. Learn from it!
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