In the children’s story, Goldilocks And The Three Bears, when Goldilocks first entered the home of the Three Bears, she came across three bowls of porridge on the table. The first bowl was too hot, the second bowl was too cold, but the third bowl was just right, so she ate it all up.

Goldilocks was willing to try out each option until she found the one that was just right for her.

Are you taking on too much (hot) or too little (cold) risk in your investment portfolio? If you are not yet sure about your answer, like Goldilocks, now is the perfect time to find out what level of risk is “just right” for you. When investing, there is no such thing as a right or wrong risk profile — it is all about identifying what works best for your unique situation. Therefore, before you begin investing, it is important that you know your risk profile by assessing both your willingness and your ability to take risks. This will allow you to create a portfolio that is not just focused on generating a particular level of return but has a level of risk that you will be able to tolerate financially. In other words, will you be able to tolerate the impact that the ups and downs of the financial markets can have on your portfolio and any potential short-term losses that are inevitable realities of investing? Will your lifestyle be compromised by a significant drop in your portfolio? Do you have sufficient funds outside of your investments to meet your needs?

What exactly is your risk profile?

A risk profile is an evaluation of both your risk capacity (ability to take risks) and your willingness to take risks (risk tolerance).

Risk capacity can be quantified and is measured objectively based on your portfolio size, the amount of time you have to meet your financial goals, liquidity needs, income, and debts, among other factors. The combination of these factors helps to determine the amount of risk you can likely handle without potential losses causing irreparable damage to your ability to meet your investment goals or fund your day-to-day living. For example, say you are in your mid-thirties with a high-paying, stable job and no need to withdraw from your investment account before your retirement, you would have a much higher capacity for risk than someone approaching retirement, with significant debt and needs to tap into income from their investment portfolio to help to cover their living expenses.

Your tolerance level, on the other hand, is more subjective as it considers your emotions and behaviours. The idea of taking risks and exploring the unknown may be terrifying for some, while it may seem exciting for others. How comfortable are you with risk? Will you be able to sleep well at night and cope with major changes in the value of your investments? Often, your risk tolerance can be identified through the use of psychometric tools (like questionnaires) or by examining your past behaviour and factors that contribute to the financial decisions you make.

Together these factors determine your risk profile, but this assessment is not an exact science. It is important to note that your ability and willingness to take risks may not always align with each other. For example, you may be comfortable taking high levels of risks; however, if you rely heavily or solely on your portfolio to meet your daily living expenses, your ability to take risks is low. It would not be wise to make a conclusion about your risk profile based exclusively on your tolerance or appetite for risk. Instead, you must carefully examine both aspects to reconcile this incongruence.

What are the types of risk profiles?

Now that we have established what a risk profile is comprised of, you are one step closer to identifying your optimal risk level (risk profile). Your risk profile can fall anywhere on the risk spectrum, ranging from conservative to moderate to aggressive.

An aggressive investor is typically one with a high-risk capacity and tolerance. This investor is willing to potentially lose large sums of money for a chance at higher returns by investing in riskier asset classes.

A moderate investor is less tolerant of risk when compared to aggressive investors. An investor with a moderate risk level can bear some risk and maintain a balanced portfolio consisting of both riskier and safer assets.

A conservative investor is one with a low-risk capacity and tolerance. This investor takes on little risk by investing in the safest assets and prioritises avoiding losses over pursuing gains from investments.

Take a moment to self-reflect; which category do you think you belong in?

Why is it important to know your risk profile?

Risk profiling is important because it allows you to make more informed decisions about the right asset mix for your investment portfolio. If you are taking on too little risk (cold porridge), this can result in the underperformance of your portfolio and may lead to missed opportunities to build wealth or to meet your financial goals. While taking on too much risk (hot porridge) meanwhile can lead to major irrecoverable losses, missed financial goals, and extreme financial/mental stress. Therefore, finding the right risk profile allows you to appropriately align the assets in your portfolio with your risk profile to achieve your desired goals. Once your risk profile is determined, a personalised, diversified portfolio can then be constructed in line with your financial goals and objectives.