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Deciding how much risk to take should be more than asking yourself whether you consider yourself risk-averse or risk-seeking. That risk tolerance is actually only one aspect of the bigger picture that you should be considering when deciding how much risk to expose your investments to. That bigger picture is called your risk profile.
Your risk profile reflects the holistic picture of how much risk you can take. It considers not only your risk tolerance or preferences, but also your life circumstances and what goals you want to achieve.
Here we’ll dive into each aspect of your risk profile and how they play a role in helping you decide how much risk you take in your portfolios.
The first aspect that makes up your risk profile is your life circumstances. Your life circumstances, such as your age, type of job, and your monthly spending needs relative to your income all affect how much risk you can afford to take on your investments.
In your 30s, you can afford to take on more risk in your portfolios compared to someone in their 50s. That’s because you have time on your side to ride out any short-term losses in your portfolio. Not only that, but riskier portfolios over the long run will likely give higher average returns than lower-risk portfolios. So, when you’re investing in riskier portfolios at a younger age, you’re better positioned to take advantage of those higher returns to grow your wealth over time.
If your income and job is uncertain, or entails high risk, it’s crucial to protect your savings from that uncertainty. Let’s say you’re a business owner that’s already exposed to the downturns in the economy through your business. Investing your entire savings into a riskier portfolio will only put you in a position where your savings could be wiped out along with your business earnings during a downturn. So, it makes sense to offset your business risks by investing a portion of your savings in moderate-to-low-risk portfolios that can sufficiently protect your savings during a downturn.
Consider Alicia, who earns $10,000 USD, and spends only $5,000 USD a month. And then consider Jeremy, who earns $10,000 USD but spends $9,000 USD a month. Alicia’s lower living expenses relative to her income allows her to put more of her savings in riskier investments compared to Jeremy. Her higher savings capacity gives her the flexibility to decide how much risk she wants to take with her savings.
Along with your life circumstances, your risk profile also considers the timeline of your goals. Simply put, you can afford to take on more risk for your long-term goals than your short-term goals.
When you’re saving up to make a large purchase in the upcoming year, such as buying a house, you don’t want to be putting those savings into riskier investments that fluctuate more in the short-term. Your portfolio could experience significant losses right when you want to use that money. Instead, investing in a low-risk portfolio allows you to still earn a return on your savings for your short-term goals while making sure that those savings don’t suffer if there’s a drop in the market.
But when your goals are 10 to 20 years away, you can afford to take on more risk in your investments because your investments have ample opportunity to recoup any short-term losses. And, similar to the age factor, investing in riskier portfolios for your long-term goals gives you the opportunity to earn better long-run returns.
The final aspect of your risk profile is your risk tolerance. In your risk profile, your life circumstances and the timeline of your goals are relatively measurable. But ultimately, each person’s risk tolerance is different, no matter what stage in life they’re in.
Just because your life circumstances allow you to invest in riskier portfolios, doesn’t mean you have to, or even should. Having more time on your hands and longer-term goals doesn’t mean you should be taking more risk; they simply mean that you don’t have to be as conservative.
If you’re someone who has a consistently high savings capacity but you’re not actually comfortable putting those savings in a high-risk portfolio, that’s okay! You can still choose to invest in medium-to-low-risk portfolios. This way, when you’re faced with the inevitable downturns in the markets, the resulting drops in your portfolio will be within a range that you can comfortably accept and endure.
On the other hand, you may have a high risk tolerance, but your life circumstances limit how much risk you can take. For instance, when your debt obligations (mortgage, credit card, car loan) are high relative to your assets, investing most of your savings in a risky portfolio will only expose you to unnecessary risk. You may think you can handle the high risk during good times, but what happens if you lose your job during a recession, and you still have to service your debts every month? You might start worrying about your investments and even make the mistake of cashing out on your investments at a loss.
At the end of the day, understanding your risk profile is about striking a balance between your risk tolerance, your life circumstances, and your goals. Aligning these 3 aspects of your profile from the start will help you choose the right level of risk for your investments so that you see through the investment plans that you set out for yourself.