Page 106 - Profile's Unit Trusts and Collective Investments 2021 issue 2

CHAPTER 6

Risk Profiles and Risk Ratings
Both funds and investors have risk profiles. The risk profile of an investor tries to describe or quantify
the level of risk that the investor can absorb if things go wrong. The risk profile (or risk rating) of a
fund is usually based on the historical volatility of the fund and/or the assets it holds. Risk profile
terminology is often used interchangeably: both low-risk investors and funds can be referred to as
“conservative”, for example. The meaning is consistent: the conservative investor is risk-averse; the
conservative fund offers a low-risk vehicle. Similarly an aggressive investor is risk-prone and an aggressive
fund has a high-risk / high-return profile.

Some questionnaires focus entirely on risk appetite; others try to evaluate risk capacity as well
(the risk profile questionnaires in this chapter address both). Generally, this strategy suggests that
as investors become more averse to risk, their investments should become more heavily weighted
in bonds and cash. Although worksheets like these are useful, they do not generally go far enough.
Other issues that need to be considered are:
Investors might also find it useful to ask not only what market risk they can tolerate, but
also what market risk they cannot tolerate (eg, identify savings you can’t afford to be selling
at a loss).
Questionnaires like the Risk Profile Worksheets, usually assumes that all investment goals
are long-term. However, this is sometimes not the case. People have different goals during
their lives with different timing. This means that no one can have one savings plan based on
the single assumption of risk level. Investments have to be structured to meet various
targets with different risk assessments for each goal.
The relative income of an investor should be considered. An investor with more disposable
income is able to take a higher risk.
An investor with alternative liquid assets is able to take on a higher investment risk: in the
case of an emergency, it is unlikely that he or she would have to sell his or her investments.
Some investors may be advised to perform this investment exercise in reverse. Instead of
starting with the question “What level of risk do I feel comfortable with?” the investor
might ask, “What level of risk is it necessary to achieve to meet a predetermined
investment goal?” Then it can be decided if that risk threshold can be tolerated.
These considerations make it clear that risk assessment goes beyond a simple questionnaire. In
designing investment strategies, the investor and financial advisor must work with four
parameters: financial circumstances, financial needs, risk capacity and risk appetite. The
interaction between these four often conflicting factors is surprisingly complex.
How much weight should be given to risk appetite is a matter of some debate. Some
commentators argue that financial needs and risk capacity are all important; others argue that
understanding risk appetite is vital.
The problem with ignoring risk appetite is that perceptions lead to actions. For example, a
risk-averse individual placed in a high-risk product (because it is appropriate to financial needs and
risk capacity) may, out of fear, offload underperforming investments at the worst possible time. A
certain composure in the face of volatility cannot be disregarded – it is a necessary characteristic for
investors who embrace the high end of the risk spectrum, whatever their “objective” risk capacity.

Starting with the Basics
There are a few basic investment principles that are worth repeating in every article or book on
investing. They include the following:
Start investing as young as possible – when it comes to investment, risk generally
diminishes over time.
Pay off all debt before investing – settling debt is a totally risk-free investment.
Make informed decisions – ignorance is probably the greatest investment risk.

104 Profile’s Unit Trusts & Collective Investments — Understanding Unit Trusts