Assessing Your Risk Profile

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David R. Evanson

Privately Published, Spring, 1995

When it comes to investing, are you a risk taker or a risk avoider? The answer to the question is vital to successful investing.

Members of the Regional Investment Bankers Association, are experts in the science of risk. As brokers and money managers to some 1.5 million investors, as well as investment bankers to emerging enterprises here and abroad, the principals of these firms have seen risk in all its shapes and sizes. When evaluating an investor for suitable investment products, they look at what the facts are saying. Age, investment objectives and income level all play an important role in helping determine what kinds of products and risks an investor should be taking.

But then there is this matter of fiber. Part of what makes up the best investment for an individual is how they feel about risk. And to solve this puzzle, investment professionals look more subjectively at an investor’s behavior to determine what will keep them up at night, and what will let them sleep.

Financial Rorschach
Consider some of tell tale clues to see if you are a conservative, or perhaps not so conservative investor.

• How many jobs have you had? A person that will be more comfortable as a conservative investor will generally have fewer employers. The less conservative investors will have moved around a little.

• How do you evaluate new situations or opportunities? The conservative investor looks at reasons why not to do things. The less conservative investor looks for reasons why to do them.
• What kind of insurance coverage do you have? If you have every angle covered, from mortgage to health, to loss of income, and life insurance, you are almost certainly a conservative investor. If on the other hand, you have little or no life insurance, that is the unmistakable behavior of a risk taker.

• Do you have a 15 year fixed-rate mortgage or a variable rate mortgage with a 5 year balloon? A risk adverse individual will have the shorter, fixed mortgage because they don’t want the rate to change, they don’t like being in debt, and they want to pay it off as soon as possible.

• Do you feel uncomfortable taking a loss when you sell a personal asset? The sale of a house, or a car, or perhaps an antique — especially in the context of a lifestyle change — can yield important clues about investment profile. A risk taker will take the loss in stride. For a more conservative investor, a loss on a personal asset can be traumatic.

• How much debt are you carrying? A high level of debt signifies a more aggressive investment posture, while low debt tends to signify risk adverse behavior. A risk oriented investor will tend to take on more debt because they are generally more confident about the future.

• Do you have a budget? People who have budgets and actually stick to them tend to make conservative investors. It’s not hard to see why. Anyone who wants to know precisely how far their money will go each week or month, will almost certainly want to know what kind of return they will get.

Risky Definitions
Of course it’s difficult to generalize, but the above quiz should send some very strong clues about your personality type investment-wise. And now that you know what you are, a speculator or a conservative investor, a few words about the concept of risk is are in order.

In a word says Long, risk is uncertainty. When the return on an investment is known with a high degree of certainty— like the return on a certificate of deposit — the risk is low. When there is a high degree of uncertainty regarding the return, such as with a small-company stock, a high element of risk is present.

Strong Relations
Historically, there is a strong relationship between risk and the returns that an investor enjoys. Consider the chart supplied by Ibbotson Associates, Chicago, which tracks the compound annual rate of return for different kinds of investments:

Notice that as the level of risk increases —read uncertainty — so too does the expected return. It’s important to keep in mind, say Long and Henderson, that taking more risk does not always translate into a larger return on your investments: it just increases the likelihood of getting a higher return. Losses can and do occur more frequently at higher levels of risk.

Reasonable Behavior
The old saying ‘a little knowledge is a dangerous thing . . . ‘ is particularly appropriate when it comes to investing. “Just because your personality may be able to withstand some risk does not mean that you should do unwise things. There is a difference between prudent risk taking and just plain taking risks.

What are some examples of unwise risks? An investor with more on the line the he or she can afford to lose is a prime example. At that point he or she is jeopardizing the future rather than investing to make it come true. Also investors that believe they have a system, when in fact they do not, are also taking very high, most likely unwise, risks.

By contrast, a prudent risk is looking for some very high returns from their speculative investments, as opposed to a home run on each one. In addition, a prudent risk taker will figure out how much he or she can afford to lose, and then invest a little bit less than that amount. That way they can always come back into the market.

And while the idea may seem far fetched at first blush, being too conservative can be just as unwise as highly speculative behavior. If your attitude is that you will not put a single dime at risk then you have a very small universe of investments for your portfolio. Many ultra-conservative investments, actually go backwards with inflation and taxes. If over time your capital gets depleted so that so that you cannot attain the objective you were saving forthen that’s hardly different from losing capital through high risk investments.

Chart copy

Risk/Return By
Investment Category

Increasing Historical
Risk Return*

Treasury Bills 3.7%
Long Term Gov’t Bonds 4.8%
Large Co. Stocks 10.2%
Small Co. Stocks 12.2%
Source: Ibbotson Associates, Chicago.