Key takeaways
Your risk profile is something unique to you and helps an adviser determine if an investment, with the risks it poses, is suitable for you.
Before an adviser recommends an investment product, he / she is obliged in terms of the General Code of Conduct under the Financial Advisory and Intermediary Services Act to determine:
Your adviser or the financial services provider should then give you appropriate advice to enable you to make an informed decision, taking into account:
A working group set up by the two main financial adviser organisations in South Africa, the Financial Planning Institute and the Financial Intermediaries Association, has defined a risk profile as the risks that you need to take to achieve your investment objectives, given your ability and willingness to accept those risks.
It has recommended that your risk profile should take into account three factors:
The risk you require is the level of investment risk that you need to take to meet your goals, given how much you are investing and your time horizon.
The risk you require is determined by the return you need to earn. This in turn determines the asset allocation you need, including the level of exposure you need to asset classes, such as shares (equities) and listed property, that have the potential to earn good returns above inflation.
The higher your exposure to these asset classes, the higher the volatility or ups and downs in your returns. This can be mitigated by investing for the appropriate investment term, as the longer you invest in asset classes with volatile returns, the more certain you can be that you will, on average, earn the return you require. Read more: What should I know about investment risk and time?
You may need to be exposed to different levels of investment risk for different goals.
The risk you can afford to take, or your capacity for risk, reflects the risk you can take based on your ability to withstand potential losses.
It should take into account your ability to absorb a fall in the value of your investment and the impact on your current or future standard of living.
Your investment time horizon, whether you need to draw an income from an investment, whether you have other investments, an emergency fund and whether you are still working and able to save, are all relevant. Read more: How do I set up an emergency fund?
If you have sufficient income, cash and / or alternative investments that can buy you time to wait for markets, and for your investment value to recover, then you have the capacity to take the risk.
In testing your risk capacity, you or your adviser should also consider whether you may, due to an unforeseen event or cash flow constraint, need to sell your investment when markets are down.
This is also relevant if you invest in a product with contractual terms that bind you to making ongoing investment contributions and for which you could incur a penalty if, due to unforeseen retrenchment, unemployment, or a reduction in income, you have to stop or reduce your contributions or even withdraw all your savings.
If you do not have the capacity to take the risk required for the returns you need, you will need to adjust your goals – what you can achieve and when. Alternatively, you can explore other trade-offs such as whether you can spend less, earn more or sell or downgrade an asset, such as your home or an investment property.
Your risk tolerance is the level of risk you would prefer to take or are most comfortable taking. It is a measure of your willingness to be exposed to the chance of capital loss.
Your risk tolerance is often described as your ability to sleep well with the investment decisions you have made.
Your risk tolerance may be influenced by your personality, your gender and your personal circumstances, such as whether or not you are married or have dependents, your income level and your knowledge of financial products and markets.
Because of this, your tolerance for risk may change over time.
In assessing your tolerance for risk, you may be asked about your comfort level with short-term losses. You should also be reminded to consider what your returns are likely to be over your investment horizon, which may be a longer period.
The aim of testing your risk tolerance is to ensure that you will stay invested for the recommended term, regardless of short-term losses, in order to achieve the longer-term average returns.
Many people will report that they can take a certain level of risk, but react differently when markets fall and they incur losses, even unrealised ones.
You and your adviser should explore the trade-off between your goals and your comfort levels and come to an agreement on the risk you are prepared to tolerate in order to target a particular return that you need, despite not feeling comfortable with it.
Advisers typically use risk profile questionnaires to determine your risk profile, but some questionnaires don’t take enough factors into account or rely heavily on your self-assessment.
However, as the way in which you answer questions in a questionnaire may be influenced by your perceptions, feelings and level of financial well-being and security, some advisers prefer to talk to you in order to gauge your tolerance for risk.
If your adviser comes to the wrong conclusions about your risk tolerance, it could result in you being overexposed or underexposed to risk.
If you are exposed to too much risk but are unable to tolerate the anxiety when markets perform badly, it may result in you selling an investment, at a bad time – when your investment is down.
If you are underexposed to risk, you will earn a lower return than you could have and this can also have very negative consequences.
Your financial adviser should record your answers or discussions about your risk capacity and tolerance. When reviewing the performance of your investments, or if extreme market conditions make you worried, your adviser should remind you of your investment goals, the risk you need, what that risk means in terms of high and low returns and whether your investment has performed in line with what you agreed you should expect.
