Investors choose different types of investments due to various factors, such as personal preferences, character, emotions and analysis. But today I would like to talk to you only about one of them: risk. Depending on the risk profile, people can be categorised into different classes of investors. These risk profiles are usually based on qualitative and quantitative factors that help to determine a specific profile for you as an investor and usually allow financial institutions to help you choose the type of the investment.
Some of the alternative investments that we discussed in the previous blog post are more risk-averse than others and may even be different entry-level investments. If we take the example of cigars, wines, cars and even shares of the specific companies, these investments are mainly for the most risk-averse profiles, as the volatility may be high, and they are largely based on demand. Therefore, there is always a risk that a person will not find a buyer at the right price and at the right time, when he/she would want to sell the investment. Meaning that most people that invest, do so as a small percentage of their portfolio and can afford to be “stuck” with their asset for a while.
Other alternative investments such as gold or certain stocks that are considered to be “very safe” (blue-chips), will be more suitable for lower-risk investors, who are looking for dividends and safe haven value (such as physical gold).
What Is Risk Appetite?
“Risk appetite can be defined as the amount and type of risk that an individual or organisation is willing to take in order to meet their strategic or financial objectives” (Risk Management Guru, n.d.). Every investor has different type of risk appetite and it is recommended to assess it once in 1 or 2 years in order to understand how you can adjust your investment portfolio, what needs to be changed and what investments should be kept. The following assessments are recommended as the risk appetite might change and be affected by the events happening in personal and professional life (e.g. divorce, marriage, promotion). Also, the risk tolerance changes with age, marital status, needs and financial net worth. For example, people below 45 years consider taking higher risks than elder people.
Furthermore, determining your risk appetite might not be easy in the beginning. There are three main aspects that need to be asses: what loss you can afford, what is your attitude towards risk and what risk is needed to be taken in order to achieve certain returns on your investments.
“Understanding what risk to take when investing is a hard thing to do without guidance because taking on too little or too much risk can be dangerous” (Calkin, 2018).
Most of the high-risk investments tend to bring a high return or growth in comparison to low risk investments, thereby it is a difficult decision that investor needs to take . According to James Hambro & Co (2019) the most aggressive investors allocate 85% in equities and 15% in alternative investments and cash.
How Risk Profiles Are Created?
Risk profiles are usually created by financial institutions such as banks and asset management companies. In order to establish how to spread the assets in the clients’ portfolio. This profile is created by following an extensive qualitative and quantitative questionnaire that includes questions about financial abilities, experience in stock market, family background, age, and total net worth. In this way, the bank or asset management firm is able to spread out the assets according to the type of profile, and is also legally protect from any issues that may arise due to any potential major losses in the finances of a client. It is considered to be part of the due diligence process of a bank to go through this process before allowing any investments, even following a client’s order.
Types of Risk Tolerance
1st Type: Very conservative
This applies to people that are getting close to retirement age and do not need to increase their capital, but are willing to hedge mostly their accounts from inflation. Also, they are looking for a steady income with lower profits, because the time they have reached a certain age, their expenses decrease in comparison with younger people, who are willing to grow their finances in order to create a family or buy a house.
2nd Type: Conservative
Investors with “conservative” type have already established their retirement date and paid off most of their loans, mortgages, but still are trying to increase their capital more than inflation. However, they are not looking to yield high returns.
Gold and Blue-Chip Stocks are generally seen to be conservative and safe investments, therefore, appealing to the more conservative risk profiles that are looking to hedge from inflation and allow a steady revenue at lower rates.
3rd Type: Balanced
Balanced investors are usually 10 to 20 years away from retirement age and are looking into having a steady growth of the investments in the market without losses. Investors will most likely have smaller share of their portfolio in the stock markets in comparison with aggressive investors in order to protect themselves from any downturns. They may also look into investments such as physical gold, stock market or real estate, because it would help to stabilise their investment portfolios as they have already build up their cash reserve.
4th Type: Aggressive
More” risky” investments such as rare cars, classic cars, collectibles, watches or art may be more appealing to the more risk averse profiles. These investments are capable of yielding very high returns over very short periods of time but they are also able to lose value over long terms. Additionally, they have very low volatility, because there is very little supply for collectibles with a small amount of demand, and if a price match cannot be reached at a time of sale then the seller may find himself forced to either sell at lower price or to have to hold onto his asset and not be able to turn it into cash immediately. This also applies to startup company investments that on the long term may pay back hundredfold just as well as they may result in a total loss.
5th Type: Very Aggressive
As an aggressive investor, most probably you are in your young age and trying to give your cash reserve a big boost and large part of it into traditional or non-traditional investments that may might have high risks. This investment behaviour and strategy would give you chance to get a higher ROI. However ,keep in mind that high risk may result in very big losses and even potentially total losses. For this type of situations, you will want to have an emergency cash reserve that you can count on.
In this post I have explained what risk profiles are and how they work, also what affect do they have on your alternate investments. We have also discovered that more risk averse profiles are usually millennials such as graduating and working adults looking for high returns. Conservative profiles are mostly elder people and the families that are either looking for a steady “low” return or for more “safe” and traditional investments that will ensure high long-term ROI.
To conclude I highly recommend anyone although the profiles that are described above are generalities, to study their risk profile with a professional in the field if possible before making any investments whether in alternative or traditional investments.
I hope you have enjoyed reading this blog and I am looking forward to further discussing this topic with you below in the comments.
Agyemang, E. (2018). How to assess your risk appetite. Retrieved March 17, 2020, from https://www.investorschronicle.co.uk/managing-your-money/2018/07/05/how-to-assess-your-risk-appetite/
B&FT Online (2019). Does your risk appetite influence your investment decision? Retrieved March 18, 2020, from https://thebftonline.com/2019/features/does-your-risk-appetite-influence-your-investment-decision/
Bryant, S. (2019). Risk tolerance and your personal portfolio. Retrieved March 19, 2020, from https://www.investopedia.com/articles/investing/040215/how-manage-risk-your-own-portfolio.asp
Guardian (2019). Risky business: what’s your risk profile? Retrieved March 20, 2020, from https://www.theguardian.com/industry-superfunds-super-new-you/ng-interactive/2019/may/28/whats-your-risk-profile
Risk Management Guru (n.d.). Risk Appetite. Retrieved March 20, 2020, from https://riskmanagementguru.com/risk-appetite/
Catherine, good afternoon. Like to read your blog. Everything is intelligible and very understandable to in-depth people in the mechanism of types of risk tolerance. Thank.
Hello Helena, thank you for your comment! Stay tunes with the new blogposts.
The article is written on a very relevant and debatable topic. It was interesting to get to know the different types of risk.
Hello, thank you for your feedback!