Sensible investment and wealth management requires a balance between your risk profile and investment portfolio volatility.

Both of these factors can be combined to make up your investment policy and investment philosophy.

It's important to understand that your risk profile is really comprised of two aspects: your risk attitude and your risk capacity. Risk attitude is the true measure of your personal comfort with risk. Are you willing to risk a less favourable outcome whilst attempting to achieve a more favourable one? (risk vs return).

Risk capacity is your ability to sustain a less favourable outcome without jeopardising your original goals and objectives. Risk capacity is affected by factors such as time horizon (allowing you time to recover from an adverse return) and total wealth (allowing you to go through a decline in account value and still maintain your desired spending).

The two areas are as important as each other and it is vital that you take both into account when making important investment decisions. For example, if your risk attitude means that you could sustain a 25% market decline without any impact on your goals, the appropriate portfolio may contain 60-80% equities.

However, if your risk attitude measure indicates that any decline in excess of 10% would cause you cold sweats and sleepless nights, then the 60-80% equity portfolio is clearly not the right approach. Instead, you should be invested into a portfolio with a lower percentage of equities.

So, how can you address your full risk profile?

There are two keys:

First, you must obtain a true measure of your risk attitude.

This can be obtained by using a comprehensive risk profiling system. You won't be able to achieve this by second guessing it yourself, as it's highly unlikely you'll know enough for the assessment to be successful. You should speak to your Financial Adviser/Planner and ask them what they're using. One of the most comprehensive tools is provided by FinaMetrica. Their assessment contains 25 questions and your score (1-100) will be compared against the whole pool of those who have completed the questionnaire.

You should then make sure you interpret the score correctly and are able to act upon the information effectively.

Secondly, you should work through a process of financial planning to determine your true goals and objectives. This step is CRUCIAL as without it, how will you know what your tolerance is for risk capacity (i.e. how will you know how much loss you can absorb without it affecting the likelihood of you achieving your goals).

Once you know how much downside you can tolerate, you can then determine what the appropriate investment policy should be, using risk attitude as a constraint. This should lead you towards deciding what percentage of equities you want in your portfolio.

The alternative approach is that you remain invested in a higher percentage of equities, but prepare yourself that you may need to adjust your goals (retire later, spend less, spend more, etc) if the portfolio value falls too much. Of course, you may reach your goals sooner if the higher risk portfolio grows at a faster rate than the lower risk portfolio.

The Financial Tips Bottom Line

When you break it all down, it's more than likely that you're trying to achieve your goals and objectives in some form. And most people would rather try and reach their goals with the minimum amount of risk (yes, note I said some people - there'll always be the risk takers amongst us).

ACTION POINT

The subject of investment risk should not be underestimated. If all you've done up to now is assess your risk on a scale of 1-10 (and believe me, this is VERY common), maybe it's time to take a more comprehensive approach. After all, it's only going to improve your understanding of your own risk tolerance and how much risk you can afford to take.