Putting your money in the stock market is scary. If you don’t know what you’re doing or how to calculate your risk profile, you could be in for a nauseating ride. Taking on too much risk can lead to sleepless nights, stressed-out days, and potentially serious losses. Taking on too little risk can crimp your investment returns and make it harder to achieve your objectives.
Risk is part of investing. Managing risk is a core element in every successful investing strategy, and the starting point of risk management is understanding your risk profile.
What Investing is All About
The reality of risk shouldn’t dissuade you from investing or even day trading. Instead, it should show you that there is more to investing than meets the eye. Watch out for overnight success stories where people sleep in a rag one day but wake up in a golden palace the next. Investment can be a very effective way to build wealth over time, but if you approach it as a get-rich-quick scheme you’re likely to be disappointed.
You need to start by understanding what investment is all about and how it can fit into your life.
The Core of Investing
Investing boils down to balancing two things: risk and reward. The more risk you take on, the more you stand to gain, and the more you stand to lose as well. That’s a problem because some losses are hard to come back from.
This is why you need to know how to calculate your risk profile before putting a single cent in the stock market. Knowing how much risk you’re prepared to accept is a key starting point for any investment strategy.
What is a Risk Profile and Why Does It Matter?
Your risk profile looks at how much risk you can afford to take on as an investor. It tells you how to balance the asset classes you invest in, i.e. stocks vs. bonds, as well as the type of assets in each class, i.e. low-yield treasury or municipal bonds vs high-yield, junk bonds.
What Makes Up Your Risk Profile?
According to Klement (2015), there are two main components to your risk profile:
- Risk aversion looks at how an investor responds psychologically and emotionally to risk.
- Risk capacity looks objectively at the investor’s situation and sees whether they can afford to take on risk.
Both of these factors are important.
Risk aversion, also labeled as risk tolerance, is a measure of how comfortable you are with risk as an investor. It is a psychological measure that tries to gauge how you would feel after a loss. While some of us might psychologically shrug a loss off and look towards tomorrow as a new day, others might find it psychologically crippling. The former investor might feel ok with an aggressive strategy, the latter should probably confine themselves to conservative approaches to investing.
There are several ways to measure your risk aversion. Some financial firms use The Grable and Lytton risk-tolerance scale , or G/L-RTS for short, to see how willing their clients are to engage in risky financial behavior. This a decent tool to assess your risk aversion. Academic studies have found that it correlates with people’s actual aversion to financial risk. And, it also has the benefit of being easy and simple to use.
So, what factors determine your risk aversion? You see, according to Klement and Miranda, 2012, three main factors determine our risk aversion:
1. Our Genetic Makeup
Some of us are more genetically predisposed to take on risks than others. It’s just the cards we were dealt at birth. Around 20 to 40% of variations in equity investments boil down to genetic differences. Researchers have even identified genomes that can explain a person’s willingness to take on financial risk.
2. Our Immediate Environment
The environment around us and the people we interact with day-in and day-out impact our risk aversion. To begin with, your financial adviser is bound to have a huge influence on your investment decisions, and you might not even be aware of it.
In addition to that, even our communities have a significant effect on our risk aversion. Even the church we go to can influence our investing decisions.
3. Our Past Experiences
The biggest determinant of our risk aversion is our past experiences.
For example, a study found that people who had lived through the Great Depression and could remember its effects had on average a higher risk aversion and were more financially conservative than those who hadn’t experienced this blight of American history. People who experienced serious losses in the 2001 or 2008 recessions are likely to have a similar attitude toward risk.
To put it simply, your risk capacity measures how much of a financial hit you can take without drastic effects on your quality of life. There are several ways to gauge your risk capacity, but we will defer to J. Concannon and say that there are three main factors to take into consideration:
1. Time Horizon
Time horizon looks at how long you plan to leave your money invested.
The longer you intend to wait before liquidating your investments, the more aggressive you can afford to be. After all, since risky investments tend to be volatile, you want to counter that volatility with longevity and to give your investments ample time to correct any losses.
2. Your Resources and Needs
Any expenses you pay will come from one of four places: your paycheck, your savings, your insurance, or your investments. The size and reliability of those sources of income – and your likely needs – have an impact on your risk capacity.
Income is important enough to have its own category, but you’ll need to consider other factors as well:
- Upcoming liquidity needs. If you plan on making a large expenditure in the near future, then you want to guard your money and avoid risky investments. Large expenditures can include buying a house, medical expenses, or paying for college tuition.
- Your emergency fund. If you were to lose your job tomorrow, how long could you live off of your investments and emergency funds before you need to liquidate investments? How long would those investments last? If you have a large emergency fund, you can afford to be a more aggressive investor.
- Your insurance level. If you have a stable, reliable health insurance plan and you’re well covered against accidents and other potential unexpected events, you can afford to take on more risk.
If you have no immediate need for liquidity, you’re well insured, and you have a substantial emergency fund (most experts recommend 3 to 6 months of living expenses) your risk capacity will be relatively high. An investment loss is less likely to cause immediate distress. The probability of needing the money in your investment portfolio will be relatively low.
3. Your Income
Finally, you need to consider your income, the one you get from sweating 9 to 5. The size of your income affects your risk capacity.
You also need to consider the stability of your income. For instance, while working at a company will guarantee you a stable paycheck at the end of every month, those of you who work as freelancers can never be certain that they will get paid come the first of the month.
Another factor to consider is the correlation between your paycheck and the overall stock market. Some people work in industries that rise and sink in perfect harmony with the tickers on Wall Street, in which case you should be cautious and avoid being overly aggressive. Those jobs could vanish in a serious stock market crash.
Moreover, you need to ask yourself how fast you expect your paycheck to grow. If you can realistically predict that your paycheck should increase every year by 6%, you are in a much better position to be financially aggressive than someone who expects their paycheck to remain stagnant over the coming years.
Assessing Your Risk Profile
Once you know your risk aversion and your risk capacity, you will be able to calculate your risk profile. That can be a complicated exercise because many of these factors are difficult to quantify. There are various methods of assessing risk profiles. We’ve already mentioned the Grable and Lytton Risk Tolerance Score, which is widely used.
What To Do After You Calculate Your Risk Profile
Once you have calculated your risk profile you have to decide how that risk profile affects your investment choices.
Obviously, there can be other mediating factors, including your knowledge and expertise in the investment world. After all, if you know what you are doing, you are in a better position to assess the risk of a potential investment than someone who is a complete newbie.
Armed with your risk profile, you should be able to have a better idea of the type of investments that best suit you.
👉 If you are someone with a balanced risk profile, then you might want to place 40% of your portfolio into an index fund, 40% into bonds, 10% in a CD, and leave around 10% for speculation.
👉 If you are prepared to take on a higher level of risk, you may wish to devote more of your profile to individual stocks.
👉 If your risk profile is higher you may wish to take on more speculative investments.
Each person will find the best setup for them. If you’re not sure how to build an investment portfolio that suits your risk profile, consider consulting a professional financial advisor.
The Last Word on Risk
Finally, if you take away anything, then let it be this.
Jeff Bezos once asked Warren Buffet, “Your investment thesis is so simple. Why doesn’t everyone just copy you?”
The Oracle of Omaha replied, “Because nobody wants to get rich slow.”
So, remember: In both life and the stock market, there are few quick wins and many fast losses. Understanding your risk profile can help you avoid those fast losses and put you on the road to long-term gains.
Do you have any questions about calculating your risk profile? Let us know in the comments below!