Understanding risk

• There are different types of risk.
• How much risk are you willing to handle?
• Although risk is a key part of financial planning, it's not the be-all and end-all.

"Risk" can mean different things to different people. It is one of the most difficult concepts to explain and far harder to measure or determine.

What is risk?

"Risk" to most people means the probability of losing some, or all, of their money, which may sometimes be referred to as your capital. But in a financial advice context, risk can also mean the likelihood of investment returns fluctuating excessively. For this reason, risk is also called "volatility"-the extent to which they jump around.

Your risk profile or risk tolerance (sometimes referred to as "risk appetite") must be established by a financial adviser to ensure that all or any recommendations they make are consistent with your risk profile.

For some, investment risk means the likelihood of losing money, while others see it as the volatility of an investment, or the chances of an asset not providing enough income to live on.

While risk may sound bad, it isn't. We just need to understand our risks, identify them and then decide how we'll manage them. After all, some risks are worth taking, some are not and some need to be mitigated.

Think about it this way: We take risks every day; when we drive, when we fly, when we choose to buy a house, when we walk across the road. This is why your attitude to risk is going to be the core of your financial plan.

A financial adviser can play an important role in educating you about risk tolerance and its possible impact in terms of the potential returns from investments and the ability to achieve certain goals and objectives.

Measuring risk profile: Many ways, no consensus

Most advisers use some form of risk-profiling questionnaire, and an example is provided in the following table. The risk profile is designed purely as an indicator that may help you understand how comfortable you are with accepting certain levels of risk before investing. You should take the time to read the questions carefully and answer them honestly as this will assist your financial adviser to develop and provide appropriate
recommendations.

The following table shows the types of questions in a risk profile questionnaire. This is a small cross-section of questions that would appear in a full questionnaire, as they can be quite comprehensive. Further, there is no set format for risk profile questionnaires.

Please select the number between 1 and 5 that best describes you

Different types of risk

Following are some of the types of risk you should be aware of and which your adviser should explain to you.

Inflation risk

Inflation is where rising costs reduce how far your money goes in terms of what it can buy. The erosive effects of inflation are often overlooked or not understood.

Reinvestment risk

Suppose you invested in a term deposit which paid 3% for a term of 12 months. At maturity, the interest rate on offer for another 12 months is 0.25%. Would you proceed or seek another option? This is reinvestment risk.

Market risk

All markets have ups and downs. The 2009 Global Financial Crisis and Covid-19 pandemic have shown this dramatically. Some market downturns and crises are more volatile than others and it's important to be aware of the timeframe of an investment in order to be able to ride out any performance bumps. Importantly, the importance of not panicking cannot be overstated.

Market timing risk

Some people believe they can time when to get into and get out of the market. In practice, this is very difficult to achieve, even for experienced professional investors. In many cases, some market timers end up being worse off.

Risk of poor diversification

The main benefit of investment diversification is to reduce the overall risk of any investments you hold. The key to successful long-term investing with a lower level of risk is to ensure that your investment portfolio is spread across a range of asset classes. In other words, avoid putting all your eggs in one basket.

Investment asset allocation

When assessing your risk profile, your adviser will look at a mix of investment types. That is, the allocation of investments across the asset classes, which can include cash, fixed interest, listed property, Australian and international shares.

Your overall risk tolerance is the lesser of the risk you are comfortable with, and the level of risk your financial timeframe allows you to take. Use the sample asset allocation choices shown in the table below as an indication of where you fit on the investment risk scale. To put things in perspective, cash is low risk and growth is high risk.

Different risk levels your financial advisers will assign to you