If you have any investments chances are that you have filled out an investor profile questionnaire and have been assigned an “investor profile”. Investor profile is based on your risk tolerance and it determines your appropriate asset allocation. Every institution has their own “version” of investor profile questionnaire, but they all are fairly similar. They have the few standard questions plus a few more to make it their own version. The standard questions relate to your investment objective, time horizon, investing experience and your volatility tolerance. The two most important parts are Time Horizon and Volatility Tolerance; why are these important and how do they affect your investor profile? Let’s take a closer look at these two:
This is almost always the first question on the questionnaires and is also the first question any adviser asks. Your time horizon is the single most important factor in determining your investor profile. Stock Markets fluctuate over time; in the short term nobody knows if it will go up or down, but over the long term markets tend to go up (yea I know not in the last 10 years but let’s leave that alone for now). Therefore the longer your time horizon the more risk you can take, because over time you will be able to make up losses from bad years (like 2008) and come out ahead.
Even if you are an aggressive investor if your time horizon is too short you will have to select more conservative investments. Although time horizon is important it is not the only factor, what if you have thirty years but you can not sleep at night if you loose 5% in any given year? Your risk tolerance is also important.
Volatility (Risk) Tolerance
Will you have a heart attack if you find out you lost 5% of your portfolio over the year? What if you lost 10%? How about 20%? How much can you loose in a given year before you start to worry? Remember markets fluctuate, how much fluctuation can you handle? This is an important question and investors should think hard before answering it. It is one thing to say “I am okay if I lose 20% in a year, it will go up again” but it is an entirely different story when you receive your statement and see your $100,000 is only worth $80,000. Investors always overestimate their stomach for volatility until they lose money, so think about it before you answer the question, try to visualize the scenario.
Time Horizon and Risk Tolerance do not make up your investor profile, but these are the two most important parts of it. If you have an adviser you most certainly have been through this, if you are a DIY investor with a discount broker account I recommend you determine your investor profile before you develop your investment policy statement and start investing.
Ray is an ex-financial adviser and the founder of Financial Highway. Currently working in the financial industry and working towards completing his Chartered Financial Analyst, CFA, designation.