What is risk profiling and why do we do it?

At Fathom, we take seriously the ‘pre-advice’ step of ‘risk-profiling’ with our clients – in fact, we won’t recommend any new investment, or a change to existing investments without this important step.

However, I’ve been doing some thinking recently (a dangerous thing apparently) about this component of investment advice and the use of risk questionnaires in general. I’ve concluded that we may not always be “the best” at explaining the relevance of what (to some) can be quite a confusing series of questions which might not be immediately relevant to the advice that you have asked us to provide. 

So to find some examples and explanations I googled the phrase “what is risk profiling” with the following results:

The three main components are risk capacity, risk tolerance, and risk requirement. It is a common technique used in financial markets where financial advisors use it to decide on investments and asset allocations associated with portfolios (Croner-i).

A risk profile is an evaluation of an individual’s willingness and ability to take risks. It can also refer to the threats to which an organisation is exposed. A risk profile is important for determining a proper investment asset allocation for a portfolio. Organisations use a risk profile as a way to mitigate potential risks and threats (Investopedia).

They sort of answer the question but not fully. So for what it’s worth here’s our take on “what is risk profiling” and why do we do it?

Let’s first understand “why we do it”

A good risk questionnaire will pull out essential information relating to (in no particular order) your investment objectives and time horizon, your attitude to investments generally, your investment experience along with knowledge of investments and markets and your capacity to tolerate/absorb losses. Every risk questionnaire is underpinned by a scoring matrix. So each answer you give will have a weighting within the questionnaire and on completion a risk profile is arrived at. You will generally be categorised as a low-risk, cautious, balanced, adventurous or speculative investor – although the results may indicate your position on a numerical scale.  This helps to inform the conversation about your investment objectives, and what is feasible in practice.

For us at Fathom this is often just the starting point. This is because all of the above and your responses to the questions can be impacted by many things such as (but not limited to) your current financial position, your health, your family situation or any general change in circumstances. 

What is a risk questionnaire?

Most people invest to achieve better returns than those available from banks and building societies. A good risk questionnaire should also begin to highlight that the route to those better returns is not always plain sailing, there are often bumps in the road that can (sometimes significantly) impact the value of your investments, often for short periods but as we’ve seen in recent years for prolonged periods of time, think.. Brexit (vote 2016), Brexit (2020, we officially left the EU 31 January at 11am),  Covid (2020), Ukraine (2022), Gaza (to a lesser extent – 2023). However ultimately, the longer that you can remain invested the greater the likelihood that your investments will outpace inflation and beat the returns from banks and building societies.

In UK retail financial services when we talk about risk we are not usually contemplating a total loss of a client’s holdings when we advise them to invest because we invest in portfolios that are diversified over a range of different asset classes (shares, bonds, gilts, property, cash etc) and geographical locations (UK, Europe, USA etc). Unlike (for example) if you buy an individual share in a company that goes bust, I’m thinking shares like – Esken Limited, BetX, Sirius Minerals (not a total loss but the pain is still with me to this day). 

So we are usually focusing on how volatile an investment might be day to day, week to week and what other factors might impact your investment that we need to consider. It is fair to say that usually the things that often significantly impact short term valuations are things that are unforeseen.  By definition, those sources of ‘risk’ cannot be anticipated by even the cleverest risk-profiler – but we can help you to anticipate how they could affect you.

Through the intelligent use of a risk questionnaire, your adviser can help you explore the ‘real-world’, practical impacts of a drop in value of your investments. Some examples of this would be:

• If markets fall and you rely on your investments for day to day living, what will be the impact on your financial position?
• If you are targeting a specific return and time horizon, what will be the impact of a downturn in the market on you achieving your goals?
• How do we differentiate intelligently between the level of risk you are prepared to take, and the level of risk that you actually need to take?
• Will you run out of money in retirement?  
• Would you be inclined to panic and sell (potentially) at the bottom of the market, crystallising your losses?

This blog is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.

The value of investments and any income from them can fall as well as rise. You may not get back the full amount invested.

Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.