The Three Pillars Of Risk
When it comes to knowing where to invest and seeking financial advice from a qualified Investment Adviser, there is generally a lot of focus placed on a client’s Risk Profile. And, for good reason, as knowing your ‘risk tolerance’ and your ‘emotional composure’ when it comes to investing, is very important.
But – Is this the only component to consider in detail when making decisions about investing?
In short, the answer is “no” – And, in this article, we will expand on how you can balance out three different and distinct areas of ‘risk’ when deciding on an investment journey.
Each ‘pillar’ should not be viewed in singularity, but rather the three should be viewed as a ‘whole’. Too often, advice is given (or taken) solely on a person’s Risk Profile. We believe there’s more to consider and will expand on this further….
We will also touch on a fourth area of how ‘Goals’ play a vital role in your decision-making process.
Let’s get started!
Pillar One: Risk Profiling
Most certainly, you should understand your Risk Profile. And, it is important.
If you would like to run your own Risk Profile and find out if you’re a ‘Conservative’ investor, ‘Moderate’ investor, or ‘Aggressive’ investor, please click here to complete a questionnaire.
As you move along the spectrum from Conservative to Aggressive, typically this would mean that your comfort level would grow to accept more ‘Growth’ exposure, and therefore more volatility and longer timeframes (5-10+ years) within investments in your portfolio.
When talking this through with clients, everyone has their own take on the word ‘risk’. To some, it’s a scary word. To some, it’s a word that means opportunity. To others, it’s a time-horizon conversation.
We have to stress, in the context of investing, taking on more ‘risk’, does not mean dialing up the chances of flushing your money down the toilet. Too often, to the uninitiated investor, this is what comes to mind when the conversation of ‘risk’ enters the advice process.
It’s important to understand that higher ‘risk’ most of the time simply refers to more growth-oriented assets in your investment portfolio, and therefore the need to have a longer-term outlook with these assets, like 10 years or more.
As you can see, it’s about being educated by your adviser and making an informed and financially literate decision.
And, as mentioned at the outset, understanding that risk profiling is merely one part of the investment/advice journey is very important.
What do we also need to consider? Let’s chat about that now….
Pillar Two: Risk Capacity
It’s one thing to understand your Risk Profile, it’s another to understand your ‘Risk Capacity’.
In short, you’ve said this about yourself (Risk Profile), but how much risk should you be taking?
You might be a 23-year-old Conservative investor – Does that mean it would be the right thing to have you invest in a lower-risk, conservative KiwiSaver fund for example?
You might be an Aggressive 75-year-old investor – Does this mean you’d load up your portfolio with longer-term volatile Growth assets?
No….
What is your capacity to take on investment risk?
If you’re younger, and you’re not planning to pull out your KiwiSaver to purchase your first home any time soon, then logic and advice would dictate a higher proportion of your wealth should be in Growth assets like Shares, Commodities, Property, and even Crypto (of course, a combination of these is recommended – diversification in other words).
If you’re close to or into retirement, you’d want to have a systematic strategy that moves you away from the volatility of Growth assets and into more income-oriented assets like perhaps Bonds or Cash products, or even Shares in companies that produce fairly predictable dividends.
What plays into understanding your Risk Capacity?
Age is the obvious first consideration. If you have 10 years or more in your investment horizon, then Growth would have a greater feature in your portfolio.
Is your job secure? Could you find another one if you lost your job?
Are you racked up to the hilt with debt with little room to breathe should anything go awry temporarily with your investment or financial position (like topping up an investment property for example – Or not needing to draw down on funds).
What is your cost of living? Are you ‘close to the bone’ with your family budget? Do you even have a family budget? In short, how much surplus can you work with?
You start to get the idea above that Risk Profiling is very different from Risk Capacity, and this could mean that there are some serious considerations you’d want to factor in if considering your investment journey as a ‘whole’. A great example of this is the very large number that it costs to fund your retirement. Would a conservative strategy get you there? Likely not…. So, do you have the capacity to push things a little to bring in a greater amount of Growth in the long-term?
Pillar Three: Actual Risks
What are the actual risks that could ‘rear their ugly head’ along the way – And, have you got a solid Risk Management/Mitigation Strategy in place to handle these risks?
I always say: It’s one thing to grow your wealth – it’s another thing to protect it!
You should take both things as being equally important.
What happens if there’s another Global Financial Crisis (expect this every 7-10 years by the way)?
What happens if you get knocked on the head, become ill, and can’t work for several years?
What if those tenants in your investment property kick holes in the walls, or do a ‘runner’ and stop paying the rent?
What if interest rates go up?
Your strategy simply must take realistic risks into account, and plan for them.
Be Prepared For Risk
This is to be prepared ahead of time. This isn’t about walking away, because risk is a very real thing that could happen. Remember, a ship is safest in harbour, but this isn’t what a ship was built for!
Silo out the risks, make a plan to manage them and move forward. ‘Fortune favours the brave’ as they say, and you will not get anywhere unless you stare risk in the eye, make a plan, and tackle it head-on.
And finally…..
Goals
The fourth area to absolutely ensure you include in your investment plan are ‘goals’.
If you’re young and you’re an aggressive investor, logic would dictate you’d have a greater ‘Growth’ asset leaning as we’ve discussed above…. BUT – If the wealth you have is to be spent (or part of it is) soon, then you won’t want to be investing in volatile, illiquid, or long-term assets.
Making sure your investments align with your goals is as important as the above Three Pillars.
Understanding your Short Term, Medium Term, and Long Term investment goals is essential to creating a portfolio and assets that match these time horizons.
As you can see, a successful strategy is one that has taken into account your Risk Profile – your Risk Capacity – Actual Risks – and of course Goals.
Go forth and conquer!