Before making an investment or buying a savings product (e.g. investment fund or pension plan), we first need to determine our risk profile.
Our risk profile and the time horizon of the investment are closely linked, as generally-speaking, the longer the investor’s time horizon is, the more risk he can assume. The longer the investment term, the more probability there is of recovering any losses.
Risk profile can be defined as the investor’s tolerance to losses. This tolerance has a purely psychological component, because every person has a different loss tolerance level. But it also has an objective component that can be determined by a variety of factors, such as:
-Age. This factor is linked to the time horizon. A younger person has much more time to recover any losses on their investment and can therefore take on more risk. An older person has less time to recover any losses and therefore will usually have a more conservative risk profile.
-Liquidity requirements. Investing money that you are going to need to cover an expense is not the same as investing money that you don’t need at the time. In the first case, it is better to adopt a conservative stance and choose low risk funds that will guarantee your capital. In the second case, higher risk funds could be more suitable.
Risk profile can be defined as the investor’s tolerance to losses
In general, investors with a conservative risk profile and/or a limited time horizon for their investments should select low risk products (short term fixed income, monetary assets). The expected return offered by these funds is lower than the return offered by higher risk assets but they are more focused on guaranteeing the capital invested.
Investors with higher risk profiles and/or longer time horizons, can opt for higher risk products that offer a higher potential return but are more volatile (equities, high yield fixed income).
The benefits of a diversified portfolio
However, whatever the investor’s profile, it is important to consider diversification. As the expression goes, we shouldn’t put all our eggs in one basket. A portfolio that is diversified by asset type, geography, sector and/or investment style will be more successful in the most adverse market conditions. Portfolios for different risk profiles can be set up: using less volatile funds for the more conservative profiles and more volatile funds for higher-risk profiles.