New beginnings: understanding risk

What is my ‘personal risk profile’?

Determining your personal risk profile is a critical component of financial planning and is a key factor when determining an investment strategy.

A personal risk profile evaluates your willingness to take risks, the level of risk you are required to take on, and your capacity for that risk. It is important that these factors be compared.

There are three components to consider:

– Your willingness to take on risk, or risk tolerance is really psychological, about attitude. How comfortable are you risking an unfavourable outcome to achieve a favourable one?

– Your risk capacity is the extent to which you can withstand the impact of, or to afford, unexpected financial events.

– These days, financial planning software can be used to determine the return required for you. The risk required refers to the level of risk you would need to assume to achieve this return.

This is not an exact science and is based on your financial goals and expectations, your financial position and prospects.

A well-defined, risk-profiling process using financial planning software and other quantitative tools, combined with advisory and communication skills, is essential to develop an accurate personal risk profile.

Aggressive or cautious: What does this mean?

The terminology and methodology used are not legislated and vary depending on the asset manager.

Most risk classifications are based on the volatility or standard deviation of the particular fund. In other words, how far the fund’s price peaks and troughs are from its mean performance.

Calculations require qualitative as well as quantitative analysis. The actual rating is subjective, requiring interpretation.

Some funds indicate risk on a scale, from low to high. Where terminology is used, such as cautious or aggressive, ask the asset manager for clarity.

Typically, investments with a higher equity component are ‘higher risk’ or ‘aggressive’ funds, whilst those with a higher cash or bond weighting are lower risk funds, based on the volatility of the fund price in the short term.

Equity markets require a longer period of investment in order to counter another risk – inflation.

These risk ratings are only intended to provide a guide or indication of the level of risk, but should never replace the need to understand the assets in the fund.

– If you have any questions you would like answered by financial planning experts, please send them to editor@moneyweb.co.za

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Saturday, April 26th, 2014 EN

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