Panorama article

Definition

A risk profile is how much risk an investor is willing to take in financial markets (say risk appetite if you want to sound more fancy).

Such risk profile is usually required by financial advisors or investment firms to customize an investment portfolio with an investor's goals and risk tolerance.

You should know straight away that a well-thought and regularly updated risk profile helps make better investment decisions.

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Let's explain it further

Let's say that we want to randomly invest some money and we are not sure how much should we buy in risky stocks, how much in safer government bonds and how much in very risk emerging market currencies. First, should we do it? Second, would such mix of assets be the correct one to meet with our goals and within a required time-frame? Third, would we tolerate the volatility (or daily changes) of such portfolio?

I mean, there are almost infinite possibilities to fill up your investment portfolio with so many potential combinations of stocks, fixed income, commodities and cash (and cryptos eventually). So how to find a healthy combination?

The answer can be found in our risk profile, which is the core ingredient for determining a proper asset allocation for our investment portfolio.

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Profile types

In practical terms, risk profiles are typically categorized in six buckets: conservative (1), moderately conservative (2), moderate (3), moderately aggressive (4), aggressive (5) and very aggressive (6).

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=> The conservative investor

You like to play safe with your money: basically, there is an evident need to avoid losses almost at any cost.

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=> The moderately conservative investor

You like to play safe, but you leave a small space for some additional risks to spice up your portfolio just a bit.

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=> The moderate investor

You like a well diversified portfolio, placing equal weight to capital protection and increasing reward. Some short-term losses would be accepted in exchange with long-term gains.

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=> The moderately aggressive investor

Ready to face temporary losses, you are demanding higher long-term gains.

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=> The aggressive investor

Ready to face major losses, you aim to significant gains in the long term.

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=> The very aggressive investor

As an experienced investor you want to maximize returns at all costs, and it doesn't matter if violent volatility is what you get back in return in the short and medium term.

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Creating your risk profile

It could not be more simple: a risk profile is defined by answering to specific questions around your general knowledge of financial markets, and/or if you have got a school degree related to investing, and/or your time horizon for investing, and/or your past investment experience, and/or individual preferences or attitudes towards risk.

Here's an example, and here's a different one.

Your answers will be scored and will link you up to one of the six profiles described above. It will then be the job of financial advisors (humans or investment systems) to shape your asset allocation boundaries and the overall risk that your investment portfolio can take over time.

Important: as your preferences will change, so should the risk profile. It is important to have regular updates to the conversation with your advisor, or to revise your preferences yourself if you act as Do-it-yourself investor.

More insights here.

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Regulation

In Europe, there is a regulation called MIFID II that aims to protect different client types (depending on their experience) with different rights. For the least experienced segment, called retail clients, the protection is higher as well as the requirements to do proper risk profiling, as discussed above.

If you are willing to know more, we found a succinct and good summary here on the key elements of the regulation.

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Final output: a tailored investment portfolio

We reported so far in the article that risk profiling is useful to define an appropriate risk level, and asset allocation, for your portfolio. Let's assume that at this point we have done the profiling questionnaire and found out our current profile. What's next?

As reported earlier in the post, each specific risk profile requires specific investment limits for certain assets. Therefore, once you get your profile, a suggested investment portfolio is the advice that follows:

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=> The conservative investor

Your average allocation: 5-20% in stocks, 95-80% in cash and fixed income instruments

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=> The moderately conservative investor

Your average allocation: 20-30% in stocks, 80-70% in cash and fixed income instruments

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=> The moderate investor

Your average allocation: 30-40% in stocks, 70-60% in cash and fixed income instruments

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=> The moderately aggressive investor

Your average allocation: 40-60% in stocks, 60-40% in cash and fixed income instruments

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=> The aggressive investor

Your average allocation: 60-80% in stocks, 40-20% in cash and fixed income instruments

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=> The very aggressive investor

Your average allocation: 80-95% in stocks, 20-5% in cash and fixed income instruments

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Those asset allocations should be a good starting point to know where to invest.

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One major issue

One of the big issues we have with the normal process tackled by human or robo-advisors is that the investment profiling and ongoing advisory ends at this point, with a proposed initial asset allocation.

And that's wrong.

In other words once an ideal portfolio, suitable to a specific risk profile, is found, money gets invested and - away from routine rebalancing to keep the shape of the asset allocation intact - the portfolios are then left drifting with the same shape indefinitely, not changing as market conditions change.

The issue with keeping a static portfolio (which tends to be the unspoken market standard) is that certain assets change their behaviors over time and can increase their riskiness. One major example is the -20% performance achieved by safe government bonds in 2022 given their sensitivity to inflation and rising interest rates. Ideally, we would have reduced to a minimum the exposure to government bonds in that period.

The solution to the wrong (mis-)management of static portfolios is to manage them dynamically, i.e. by systematically changing the portfolio exposure to different instruments - within the limits required by the risk profiling we now understand well - as the economic cycle advances. We are writing a full article dedicated to the topic.

At Monetharia, we are developing a one-stop investment system working in all weathers and that dynamically changes along the economic cycle, that can be invested by individuals with different profiles inside their specific risk limits.

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