Risk Profiler – Find Your Investment Fit.

Risk Profiling – A Practical Approach to Understanding Your Investment Risk

Over the past few years, we have developed our own Risk Profiler to help clients make informed investment decisions. Now, we are making this tool available to everyone. Unlike many risk-profiling tools designed primarily for regulatory compliance, ours is built on practical experience and a deep understanding of investor behavior, both of which are essential in managing personalised portfolios.

We have refined our approach based on industry best practices, including principles outlined in the CFA Institute's Investment Risk Profiling: A Guide for Financial Advisors, along with insights from working with clients. This has helped us develop a structured yet practical tool that assesses two key dimensions:

• Risk-Taking Ability:  Your financial capacity to take on risk, based on investment horizon, withdrawals, and reliance on portfolio income.
• Behavioural Loss Tolerance: Your ability to remain invested through market fluctuations.

This tool provides a structured foundation for us, as your financial adviser, to analyse and discuss how these factors interact to aid in portfolio construction decisions.
While “risk need” is a separate consideration primarily determined by the required rate of return (ROR), our process ensures that risk-taking ability and behavioural loss tolerance are effectively reconciled into a portfolio strategy tailored to your investment profile. We cover the “risk need’ concept in our Goals and Objectives sections of our fact find.

The feasibility of an investor’s ROR is assessed based on market conditions, financial objectives, and the level of volatility they are willing to accept to achieve that return. Ultimately, these factors determine whether an investor’s desired ROR is realistic and sustainable, as they are directly tied to risk-taking ability and behavioural loss tolerance.

For investors with high return expectations but a limited risk appetite, this typically leads to two key considerations: increasing contributions or extending the investment timeframe to achieve their financial goals without taking on excessive risk.

Given our extensive discussion on risk, it’s worth clarifying what it means in this context. Here, risk refers to the potential for financial loss in an investment decision, typically measured by downside portfolio standard deviation or, more simply, volatility.

How It Works: A Structured Approach to Risk Profiling

Expanding on the concepts of Risk-Taking Ability and Behavioural Loss Tolerance, it is essential to understand how these factors influence investment decisions. Risk-Taking Ability determines how much financial risk an investor can afford based on objective factors such as investment horizon, liquidity needs, and financial capacity.

Assessing Risk-Taking Ability

An investor’s Risk-Taking Ability is shaped by three key factors:

• Investment Horizon: The longer the timeframe before needing funds, the greater the ability to withstand market fluctuations. Investors with shorter time horizons may need to prioritise stability.
• Liquidity Needs: Investors with frequent or significant withdrawal needs have less flexibility to take on risk, whereas those with minimal liquidity needs can adopt a longer-term approach.
• Financial Capacity: This refers to the ability to absorb losses without affecting financial stability. It depends on available assets, income sources, and overall net worth.

Risk-Taking Ability Levels

Assessing Behaviour Loss Tolerance
While Risk-Taking Ability can be measured using objective financial data, Behavioural Loss Tolerance is more complex and unique to each investor. Unlike time horizons or liquidity needs, which can be quantified using financial models, behavioural factors require deeper evaluation. These insights are typically gathered through structured questionnaires, investor discussions, and, in some cases, an analysis of past asset allocation decisions. Relying on a single input can lead to a misinterpretation of an investor’s ability to handle market fluctuations.

Key Elements of Behavioural Loss Tolerance

An investor’s Behavioural Loss Tolerance is shaped by six key elements:

• Risk Tolerance – The willingness to take on financial risk.
• Risk Preference – Personal comfort with different levels of risk.
• Financial Knowledge – Understanding of financial markets and investment principles.
• Investing Experience – Past exposure to market cycles and investment decisions.
• Risk Perception – How an investor interprets and reacts to risk.
• Risk Composure – The ability to stay invested and make rational decisions during market volatility.

Behavioural Loss Tolerance Levels
By incorporating these behavioural factors, our Risk Profiler provides a well-rounded assessment, ensuring that investors' portfolios align with both their financial capacity and emotional tolerance for risk.

Understanding Your Risk Profile

Investment decisions should be guided by more than just gut instinct. Our Risk Profiler provides a structured assessment of your investment approach using a traffic light system to evaluate how well your Behavioural Loss Tolerance aligns with your Risk-Taking Ability.

Traffic Light System

   Green Light: Your Behaviour Loss Tolerance matches your Risk-Taking Ability, indicating a well-balanced investment approach.

   Yellow Light: Your Behaviour Loss Tolerance is lower than your Risk-Taking Ability, meaning your investment profile is more conservative than your ability allows. You may want to consider a higher-risk profile to pursue better long-term returns.

   Red Light: Your Behaviour Loss Tolerance is higher than your Risk-Taking Ability, which limits your investment risk level. This could restrict your ability to achieve higher long-term returns.

Once we determine your Behavioural Loss Tolerance and Risk-Taking Ability, we classify you into one of the following investment profiles. This classification serves as an essential discussion point between you and your financial adviser, particularly when there is a mismatch between your willingness to take risk and your financial capacity to do so. At this stage, a deeper conversation can help align these factors, ensuring that your portfolio is structured to best support your investment goals.

Portfolio Composition: Income vs Growth Assets & Strategic Asset Allocation

By default, the lower scoring factor between Risk-Taking Ability and Behavioural Loss Tolerance determines the portfolio composition. However, in cases of misalignment, adjustments may be made based on improved understanding through discussion. This is where subjectivity and professional expertise come into play, ensuring the portfolio reflects both financial realities and an investor’s evolving risk perspective. A change in circumstances and financial situation may also impact an investor’s risk profile, requiring adjustments to the portfolio to maintain alignment with their evolving objectives.

Strategic Asset Allocation (SAA) serves as the foundation for long-term investment performance, typically over a period of 10 years or more. Taking into perspective correlation and diversification, which are key in managing overall portfolio risk, SAA further categorises portfolio composition across multiple asset classes, including New Zealand, Australian, and international markets, ensuring effective risk management. However, regular reviews are conducted to maintain robustness and ensure the allocation remains aligned with evolving market conditions and client requirements.

Why It Matters

Understanding your investment risk profile is essential to ensuring that your financial strategy aligns with your goals, time horizon, and comfort with risk. A well-structured approach balances risk need, risk-taking ability, and behavioural loss tolerance, helping you build a portfolio that works for you - not against you.

Our Risk Profiler takes the guesswork out of the process by providing a clear and objective assessment of your investment profile. Whether you're a conservative investor looking to protect your wealth or a growth-focused investor seeking higher returns, knowing your risk profile is the first step toward making informed, confident investment decisions.

Ready to discover your risk profile? Click on the following link to get your results.
https://www.yovich.co.nz/risk-profiler

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