Begin To Invest 3 – Your Risk Profile

In 2015, I happened across the Financial Independence Retire Early (FIRE) movement. I wasn’t actively looking for direction in our financial life, but I had been living with a vague discomfort that we could be doing more. FIRE galvanised me to once again take control of our money.

In 2016 we tracked spending, and saved an emergency fund. The next step was beginning to invest – but how? The idea of investing was scary. There are so many options, traps and pitfalls for the unwary that I wanted to be fully prepared before we started. This series of posts is about the resources we used, and the steps we took to ensure a level of comfort before diving in. Mr. ETT and I sat down once each weekend to work through these steps together. At the end of each post, there is a link to the resources we used.

In Part 2, we investigated the theory behind risk, volatility and timescale. This time we perform some practical exercises to help apply the theory to ourselves as investors.

Investing Is Emotional

As we explored last post, investments have risk and volatility levels, while you have a risk tolerance, a certain capacity for loss, and a timescale for investing. You need to balance all of these factors to find the best investment for you. Humans are not machines (well, sometimes we are partially machines). If investing was simply the case of placing your money where perfect complicated mathematical equations told you to place it, then the stock market wouldn’t exist. Investing is uncertainty, and humans react to uncertainty with emotion. Only you know best how you deal with strong negative and positive emotions. The exercises in this post will help you to:

1/ Choose investments that best suit the level of risk you are comfortable with.

2/ Plan ahead to put rules and boundaries in place, to help you deal with events if they are likely to trigger your risky behaviour.

Mind Games – You Lost How Much?!

Start with a few mental exercises. This will hopefully consolidate your understanding of how you might react in certain situations, which will then help you to complete your risk profile. How would you feel if, once you are on your way, your investment dropped by 10%? 20%? 30%? As Pete Matthew from Meaningful Money points out, talking in percentages is rather abstract. It doesn’t have the solidity of talking in $ (or £ or ¥ or € etc.). There’s a big difference between saying “Oh, my investment dropped by 10%” and “My investment has dropped by $100,000!”

Begin by thinking about the amount of money that you would like for one of your goals. We thought about the amount of money that we want to be able to retire early, which we put at $1,000,000 (still sounds absolutely ridiculous). In fact, it sounds so ridiculous that we couldn’t make the exercise feel real to us based on that amount of money, so we dropped it by a factor of 10. If our investment was chugging along nicely with $100,000 in it, how would we feel if it dropped by…

  • $10,000? We decided we’d both feel OK with still having $90,000 and a chance to recover the lost 10%.
  • $20,000? Yep, still feeling OK. We’d have $80,000 sitting there with a chance to recover the lost 20%.
  • $30,000? Mr. ETT felt that he wouldn’t feel comfortable with a loss of 30%. I’d still be happy with $70,000, as long as I had done my research. I would probably be doing a lot of research at that point, and referring back to my plans to stop myself doing anything on the spur of the moment. That’s what this is about – putting in measures to guide you when your emotions are all stirred up.

Once you have a feel for how much loss you can stomach before worrying/feeling sick/finding the next passing spaceship and getting a ride off this planet, you have an indicator of the type of investment you may consider. If you could lose up to 10%, then you are looking at a cautious type investment (for example, half in shares or property, half in cash/fixed interest). If you could lose up to 20%, then perhaps a balanced portfolio might suit you (half to two-thirds in shares/property, the rest in cash/fixed interest). 30% is for the more adventurous type investments (up to 90% in shares or property).

Our brains are pretty good at catastrophising!

Mind Games – Your Net Worth Dropped by What?!

Write down how much you are planning to invest. If you are thinking of making regular deposits, then for the purposes of this exercise, think about how much you will invest in the first year. Then add up the total amount of money you have easy access to – money that isn’t tied up in houses or cars or term deposits and so on.

Mr. ETT and I have earmarked about $50,000 through a combination of a lump sum to start, followed by regular investments. Right now we have about $100,000 in liquid money that we can easily get our hands on (sounds crazy, but we have 1/3 of that in a managed fund that I’ve had for nearly 20 years, and all of 2016 we were saving for the time we would begin investing. This amount includes budgeting for 3 full months ahead, as well as an emergency fund of about 3 months worth of reduced expenses). Once you have those two numbers, work out the percentage of your easily accessible money that you are planning to invest.

$50,000$100,000 x 100 = 50% of our “liquid” (easily accessible) wealth.

Next, we look at a worst case scenario – if the value of your investment dropped by 50%, what does that do to your total net worth? If we invested the night before a major market crash, and we lost half of the value of our investment, then that’s $25,000 down the toilet if we need to take the money out for any reason.

$25,000$100,000 x 100 = 25% of our TOTAL “liquid” (easily accessible) wealth.

Now, that’s above the threshold that Mr. ETT is comfortable with, and below mine. However it really is worst-case scenario. In the first place, we would hope to never be forced to remove money quickly, but life throws terrible circumstances at ordinary people all the time. So if it did happen, then we still have access to $50,000 quickly, and $25,000 from the depleted investment. We also have insurances in place.

Instead, what if I had $10,000 liquid wealth, and I was planning on investing $9,000 of it?

$9,000$10,000 x 100 = 90% “liquid” (easily accessible) wealth.

If the market dropped by 50%, just as I was forced by life to take my money and run,

$4,500$10,000 x 100 = 45% “liquid” (easily accessible) wealth.

That means I would have lost access to nearly half of all the money I had saved up, and I would have $5,500 left. You’ve seen our budget breakdown – that’s about what we spend in a single month (we’re trying to get better!).

In the first scenario, we can afford to look consider riskier investments, such as shares and property. In the second scenario, if that was all the money you had, you shouldn’t be investing in the first place. However, assuming you have an emergency fund in place, investing this amount of your liquid wealth would probably mean you should be considering a more cautious investment type, such as half shares/half bonds.

Identifying Your Risk Profile

What is your Risk Profile? You risk profile gives you a clue as to what investments may suit you. It simply helps you to identify the level of risk that you can take with your money that still allows you to sleep at night, if the worst were to happen. There are some simple, free tools that will help you calculate your Risk Profile, but before we get started, it’s important to keep in mind these points:

1/ Your calculated risk profile is just a starting point. There are still factors that can influence or even change this. For example, now I have been educating myself in personal finance for over a year, my financial literacy has increased. What I would have been afraid of in the past, I now understand. This has increased the level of risk I am willing to undertake in order to gain rewards from investing. You may want to consider repeating these exercises every 5 years or so to see if anything has changed.

2/ The tools are simple. Five questions can never identify all there is to know about you or your life or circumstances. They should be taken as starting points to help you understand yourself and your attitude to risk. You are the expert in you!

HESTA Risk Profile

HESTA is our Superannuation provider, so this seemed like a good place to start. They describe their calculator succinctly – “The purpose of the calculator is to provide information to help you gain an understanding of your attitude towards investment risk. Based on the information you provide, the calculator will provide a generic description of a typical investor type.” They don’t know you, but they are helping you to understand yourself.

Mrs. ETT's results in the HESTA Risk Profiler: Aggressive
This tool designates Mrs. ETT as “Aggressive”.
Mr. ETT's results in the HESTA Risk Profiler: Assertive
Mr. ETT is likely to be “Assertive” in his investment approach.

Vanguard Investor Questionnaire

Vanguard. The organisation everyone talks about as suitable for the average “mum and dad” investor. Highly respected, and the largest player in their field. Why wouldn’t we see what they have to say? Having been reading about personal finance and investing for over a year, I found it difficult to answer some of the questions in their investor questionnaire honestly. For example, the question:

A screenshot of a question from the Vanguard Investor Questionnaire.
But I know what the answer should be…

Australia came through the GFC relatively unscathed. And 9 years ago, I had no knowledge of the world of FIRE or Personal Finance. And yet, I was still aware of what happened, and the consequences. I also know what the “right” answers to the question above are. That made it difficult for me to answer the question honestly. Or perhaps I can learn lessons from the past, and change my behaviour to suit? Also, the questionnaire seems to be directed towards people who are already investing. For example, question 6. “During market declines, I tend to sell portions of my riskier assets and invest the money in safer assets.” All you can do is pretend and try to determine what you would do.

At any rate, our results were:

Vanguard Investor Questionnaire Risk Profile Result 80% Stocks 20% Bonds.
Mrs. ETT again comes out as the more aggressive investor.
Vanguard Investor Questionnaire Risk Profile Result 60% Stocks 40% Bonds.
Mr. ETT again comes out as the less aggressive investor.

Well, after two questionnaires, we are starting to see a pattern. This helps to validate that we are on the right track for identifying our investor preferences.

InvestRight Personality Quiz

It appears as if InvestRight is Canada’s equivalent to ASIC’s MoneySmart for Australians. They take a different (and welcome) approach to identifying your risk profile, by looking at aspects of your personality with their Personality Quiz.

InvestRight Personality Quiz results for Mrs. ETT, who is "Reserved".
Yup. This is me.
InvestRight Personality Quiz results for Mr. ETT, who is "Tumultuous".
Yup. This is Mr. ETT

Isn’t it interesting that we are both unlikely to work with an investment advisor? I’m happy not to at the moment, but I feel that I will probably want to consult with one once we are getting close to retirement. Also, I have to say that Mr. ETT is pretty savvy in the fraud/scams department, so I don’t think it’s a big risk for him.

Assign Your Risk Profile

Now you have an idea about:

1/ How much you would be able to tolerate an investment going down by, while still sleeping at night;

2/ How much money you are comfortable investing compared to how much you want to keep “risk-free” for easy access;

3/ Your risk profile.

None of these are fixed in stone! These have been mental exercises only. Sometimes we can’t predict how we will react to circumstances in real life. This isn’t a test where you get a single score and it sits with you for your entire life – if you feel it it no longer applies, or if something changes, come back and look at the exercises again.

The next step would be to revisit your goals with the answers to all the above in mind. For each goal, using your risk profile as a starting point, decide on the type of investment that might suit you, based on your tolerance, capacity, and the timescale. As an example, if you were profiled as a cautious investor, but you plan on investing small amounts over a long time, then you may be able to increase your investment style to balanced, because the long timescale can reduce risk. On the other hand, if you were a balanced investor who wanted to realise some gains in the short-term, you may need to take a more cautious approach. Whatever you decide, always take the minimum amount of risk needed to meet your aims.

Before we begin to assign our risk profiles to the ETT goals, we need to better understand investment types. What’s the difference between shares and bonds? Property and REITs? ETFs and P2P? So many acronyms to explore in the next post of this series.

Did you take the InvestRight Personality Quiz? Share your results below – how do they match up with how you see yourself?

Resources

The resources we used to help us begin to invest step by step.

Meaningful Money Podcast, Season 2, Episode 2: Risk, Volatility & Timescale

ASIC’s MoneySmart – Investing Between the Flags

ASIC’s MoneySmart – Goals and Risk Tolerance

Australian Investor’s Association – Your Risk Profile

HESTA Risk Profiler

Vanguard Investor Questionnaire

InvestRight Personality Quiz

3 thoughts on “Begin To Invest 3 – Your Risk Profile

  1. I’ve never really thought about my risk profile before. I’m of the view that I only invest money in shares I’m happy to lose (well not happy but I wouldn’t be broke if it all went bust). Does that make me cautious or assertive?
    I can only have this view because I know I have the security of 9-12 months of living expenses in cash and am confident I could easily get another job if that were necessary. If that were not possibly I have income protection and other insurances.

  2. Hi Mrs. ETT, thanks for linking to my article. Having those emergency funds available is so key to both being able to deal with whatever life throws at you. In terms of investing, they help you be able to ride out the down markets without needing to panic and sell at the wrong time. It’s so true that you can’t know what you would do in a down market until you’re there. I did invest through the Great Recession (what you call the GFC) and I’ll tell you from personal experience that living through the downturn is much different than theoretically thinking about what you would do in a downturn. Luckily I did not sell – but my husband had to talk me off the ledge by quoting Warren Buffet back at me. Now my husband is not a money guy, but he’d been listening to me talk for years, and I was lucky to have someone there to help steady me when I was watching years of savings evaporate in a matter of weeks.

  3. How interesting! I would have classed myself as aggressive, but the Hesta questionnaire came back as assertive. I will continue to play around with these tools and see where they come out, and then figure out if I should take them into account for our own planning and decisions. Thanks Mrs ETT!

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