Your individual investment risk profile is the primary consideration when choosing an asset mix that is best for you. Having your risk profile assessed will allow you to reach your investment goals while staying confident during all market cycles.
In this blog post, I will show you how to define your own risk profile and how it will affect your investment selection.
What is risk anyways?
Risk can mean different things to different people.
You may consider risk as the potential to lose all of your money. Others could think of risk as running out of money in retirement.
For the purpose of this post, we will assume risk to mean market volatility.
We can then break risk levels into the following 3 elements:
- Risk Need
- Risk Ability
- Risk Tolerance
After we discuss these elements, we can then see which asset mixwould best suit your ideal risk profile.
Risk Need is how much risk you need to take to meet your goals.
Start by figuring out how much you would like to have, and when you would like to have it by. Then use a financial calculator, like this one, to find what rate of return you would need based on what you will continue to contribute, if any. You will need to use your discretion here and decide if this rate of return is realistic or not. Don’t expect to turn $10,000 into $100,000 in 5 years while making 0 contributions.
You can then use your required rate of return to gauge your risk need.
For example, I would like to turn my $100,000 into $500,000 in 15 years, while adding $5000 a year. Using the above calculator, I determined I need a rate of return of approximately 8.82%.
This would place me in a higher need for risk, as with current market conditions, I would need all of my portfolio in equities to achieve that return (more equities = more volatility = more risk).
On the other hand, if I only needed a 3% return, and interest rates were higher than they are right now, I might be able to get that return with very little equities, causing my need for risk to be low.
A rule of thumb is that if you need 70% or more equities to achieve your required rate of return then you will have a high need for risk, if you need less than 30% equities you will have a low need, and anywhere in between will be a moderate need.
Once you have your risk need figured out, you have to see if your risk ability will allow you to take on that risk.
Risk Ability is your ability to take on risk based on your investment time horizon and need for cash.
If you are 10 years from your investment goal, you are more able to take on risk then if you were only 5 years from your goal. This is because you have time to recoup any losses your portfolio might suffer in the short term.
Your need for cash is determined from how likely you are to withdraw from your investment account. If you foresee the need to withdraw from your account then your risk ability will be lower. If you don’t expect to be making withdrawals, your risk ability will be higher.
Another factor that will affect your need for cash is how dependent you are on the investment funds. If you are still employed or have other income sources, you will not be using your investment funds for living expenses and therefore are more able to take on risk.
Whereas if you are retired and relying on your portfolio for income, you would be less able to take on risk.
You can generally consider yourself with a low ability for risk if your investment goal is 5 years or less away, or you anticipate a withdrawal rate of at least 5% and have no other income sources or assets to cover you in the short term should there be a major market correction or decline.
Your risk ability can be considered high if you are at least 10 years away from your investment goal, you do not plan to withdraw more than 5% (or any) of your portfolio, and you have other income or cash sources (emergency fund, insurance, other savings) in the event of an emergency.
If none of the above scenarios apply to you assume a risk ability of moderate.
Risk Tolerance is more subjective than need or ability and will take some self-reflection to come up with an accurate analysis.
At its root, your risk tolerance is directly related to how comfortable you are with the market.
You might not care what the market does in any given month and may be very comfortable with your portfolio value ticking up then down, as you are confident your strategy will give you the returns you are looking for.
On the other end of the spectrum, you might lose sleep or even sell your holdings at a loss if your account value falls more than a few percent.
If you are unsure about where you fall, ask yourself the following questions:
Would you rather have a portfolio that is more predictable or would you be willing to sacrifice certainty in order to achieve potentially higher returns?
How knowledgeable are you about investments?
How experienced are you with investments?
How did you behave (or would have behaved, if you were old enough) during the last recession?
Did you sell off some of your holdings, buy more or decide to wait it out?
Did you want to sell off, or buy more?
Did it make you uneasy or stress you out, or did you see it as an opportunity to get in at a bargain?
If you have lots of knowledge and experience with investing, and view the stock market as a safe way to grow your portfolio over the long-term, then you are considered to be more tolerant of risk.
If you don’t feel like you know enough, lack experience, or view the stock market as risky, or even as a gamble, then you are considered to be more risk averse.
Give the questions some thought, then decide whether you are risk tolerant (high risk), risk averse (low risk), or somewhere in between (moderate).
Now that you have an idea where you stand in the above risk categories, you can start to weigh them out until you find your ideal risk level.
Start by comparing your risk needs with your risk ability. If your need is higher than your ability then you will need to revisit your goals and try to come up with a way to reduce your needed risk. This can be done by either postponing your target date, reducing the target value, increasing your contributions, or a combination of all three.
Once your need is either lower or the same as your ability, compare your tolerance with your ability. If your tolerance is the same as your ability, you now know your ideal risk level.
If your tolerance is lower than your ability and lower than your need, then you need to either go back to revise your goal again, or invest in lower risk investments until you gain more knowledge and experience.
If your tolerance is higher than your ability, again you might need to invest in relatively less risky investments until you are more able to take on risk.
Now that you have your own investor risk profile you can choose an asset mix that meshes well with it.
Your Asset Mix
Your asset mix is the allocation of different asset classes for your entire portfolio. It is often expressed in percentages of equities, bonds, cash and if you use them, GICs.
There are no hard and fast rules saying for a particular risk level you must allocate a specific percentage to equities, and most likely, your ideal asset allocation will likely change over time as your risk profile changes.
To give you somewhere to start you can use the rule of thumb mentioned above where a high risk profile would use a minimum of 70% equities, a low risk profile might use a maximum of 30%, and a moderate risk could be anywhere in between.
You can use your risk tolerance to guide you along the spectrum of equity weighting as long as you don’t break the rules regarding your risk ability.
For example, if I had a low risk need, a moderate risk ability, and high tolerance, I might want to go for an 80% equity allocation. I wouldn’t be allowed to though since whatever is limiting my risk ability would be my limitation disallowing a high-risk (high volatility) portfolio.
On the other hand, if you were to have a high need, high ability, and high tolerance, nothing would be stopping you from having a 100% equity portfolio. You could even have a 100% bond portfolio if your risk profile suggests your need, ability and tolerance are all low risk.
All-in-one ETFs to Suit
Here are some popular asset mixes in order from least risky to most risky and a 1 fund ETF solution that will get you that asset mix in one trade.
|XBB||100% Bonds||Income portfolio for lowest risk profile|
|XINC||80% Bonds, 20% Equities||Income portfolio for low risk profiles|
|XCNS||60% Bonds, 40% Equities||Conservative portfolio for lower risk profiles|
|XBAL||60% Equities, 40% Bonds||Balanced strategy for moderate risk profiles|
|XGRO||80% Equities, 20% Bonds||Growth strategy for higher risk profiles|
|XEQT||100% Equities||Aggressive strategy for highest risk profiles|
Now you know how to assess your risk profile yourself and have some funds to choose from based on the asset mix it suggests. If you need an account that lets you purchase these ETFs for free I have a guide on how to open an account with Questrade here.
As always, if you have any questions or need more help, leave a comment below or reach out through my contact page.