Understanding Investment Risk Profiles

Investment advisers and the investment industry has continuously stressed the importance of diversification and asset allocation, however investors have often ignored this, as they were too busy chasing high returns. Since the market meltdown over a year ago investors have learned a hard lesson that asset allocation is vital to an investment portfolio. In this article, we’ll take a look more closely at asset allocation and the five main investment risk profiles.

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Ibbotson and Kaplan have shown that 90% of portfolio variability is due to asset allocatio, according to those stats only 10% of your portfolio performance is due to your individual securities while 90% of it is determined by how you have distributed your money. This goes to show the importance of asset allocation. Stocks and bonds are usually not correlated and move in different directions, so a mix of both will reduce your volatility and one can set off the losses in the other. The fact that having a mix of both provides a better return than just 100% stock or bonds this is known as the efficient frontier.

What is Asset Allocation

Asset Allocation is how you divide your funds between the different asset classes — e.g., equities, fixed income and cash. How do you determine your asset allocation? Usually it is tied to your investor profile which you fill out with your advisor, this determines how much risk you should take.

Five Investment Risk Profiles

Once you fill out the investor profile questionnaire and determine your asset allocation you will most likely fall within one of the groups in the asset allocation model — i.e., investment risk profile. These models are designed to help investors and advisor in categorizing their preferences.

1. Capital Preservation

This category is for those often with short time horizons and who are just looking to save their principle.
They may need access to the money within the next 12-24 months. This could be for house down payment, car payment, education, a trip or anything else that would require the money to be there in its whole. Often retirees will also fall in this category, as they need to preserve their capital to ensure it will last them. The goal is to protect your capital and earn a very small amount of interest.

2. Income

This portfolio is designed to generate income and not so much growth, it is often for retirees who have invested throughout their working life and are now living of their retirement funds. Often the funds will be invested in bonds, corporate bonds and government bonds, with small portions dedicated to equities. The investor is not concerned with growth but wants the safety of income hence the heavy bond weighting.

3. Balanced/Income-Growth

This is the most common category investors fall in, this portfolio is designed to contain both equities and fixed income securities. However it because it is called “balanced” it does not mean it is split 50/50, it often has a range. The goal of this model is to provide capital gains along with income, it is aims to reduce volatility. Pretty much anyone can fall within this category.

4. Growth

A somewhat more aggressive category, it aims to provide capital appreciation and little or no income. Typically majority of the funds will be invested in equities and very little in fixed income. A typical investor would be a young employed individual who is looking to increase their net worth and do not care much about income or capital preservation.

5. Aggressive/Speculative

This is the most aggressive category and not many investors fall in this category. I think this is more speculation than investing, the investor in this category is in for the quick buck. Funds are usually invested in small caps and emerging markets. This category is for those with a lot of risk appetite and can often end up hurting the investors.

What are your thoughts on asset allocation? What category do you belong to?

About the Author

By , on Oct 12, 2009
Ray
Ray is the owner and primary author of Financial Highway, where he discusses investing, saving and practical money management concepts. You can subscribe to his RSS feed or follow him on Twitter.

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Leave Your Comment (7 Comments)

  1. incometaxguy says:

    One should only risk what one can do without and not risk all he has. Along with this one should also take profits then invest and save a portion of the proceeds instead of leaving it all on the table to let the market chew it up.

  2. Paul Puckett says:

    Mike Piper is correct about the correlation of stocks and bonds currently being slightly positive. The important thing to remember about correlation is that it changes constantly. The longer the time period, the more consistency in determining how assets correlate. Last year, almost all asset classes were positively correlated because almost all fell. Gold and other commodities were negatively correlated during 2008. Over longer terms, bonds and stocks have historically not correlated, however, they have correlated more often than not for almost a decade.

    The other issue to consider is that risk profiles and risk profile questionnaires are the beginning of the asset allocation decision. Developing an Investment Policy Statement that shows what asset classes you plan to use, what percentage of the portfolio goes into each class, and what determines when you rebalance (based on exceeding a percentage range or on a set time period) should be included in this statement. Asset classes for most professionals have broadened within and beyond stocks, bonds, and cash. Most advisors include mid and small cap stocks, international and emerging markets in the asset allocation. Bonds also can be separated into numerous classes from Treasuries, Muni’s, Corporates, and further into short-term, intermediate, and long-term. High yield bonds rarely correlate with other categories of bonds. Including commodities such as gold and other precious metals can also be appropriate for investors.

    Although emerging markets and small caps can be more volatile than some of the other equity styles, I’m not sure that I would agree that investors often get hurt in these styles assuming that they are using mutual or exhange traded funds. These equity styles are perfectly appropriate even for retirees when limited to no more than 5% of the equity portion of the portfolio for emerging markets and 10-15% for small caps.

    Regardless of the asset class, using funds for makes sense and, like Mike, I believe that using at least a core of index funds lowers expenses and may also limit the volatility associated with investing in individual stocks.

    As for me, almost entirely equities because my time horizon is long.

  3. Paul Petillo says:

    Nice post Ray. I am worried though that younger investors will take too little risk and those that should be taking a healthy dose of risk (the forty plus crowd), will take less than is needed.

    I just completed a post that uncovers the possibility the too little risk, as some have suggested, is more dangerous that too much risk. I am beginning to believe that the bonds underlying much of this flight-to-no-risk are not immune to a downturn. As the US Treasury flirts with endangering its own superior credit rating, I’m worried that some folks will find their retirement futures put off even further.

    Even someone who is entirely indexed will do far better over the next twenty-five or so years than an investor who allocates too much of their portfolio to bonds and other types of conservative investments (via balanced or lifecycle funds). I have some interesting evidence to back up this assumption.

    The full article, in case anyone is interested can be found here: http://retiringwithaplan.blogs.....ittle.html

  4. Savior says:

    I am aggressive/speculative. Speculation implies gambling, however, and I believe that I have an edge in knowing how the market and different asset classes perform over time.

    To ensure that one’s assets grow adequately until and throughout retirement, one will need to have at least a balanced allocation. Anything more conservative and inflation/withdrawals will eat through the portfolio.

  5. Mike Piper says:

    The data I’ve seen actually indicates that stocks and bonds are positively correlated. (Though the correlation is low, thereby still resulting in lower portfolio volatility if the two are combined.)

    In contrast (again, from the data I’ve seen), gold actually has a negative correlation to stocks, making it an even better diversifier. (Though on its own, gold’s volatility is tremendously high, making it probably a poor choice for more than a small portion of a portfolio.)

    As to the actual question posed, I’m aggressive in my asset allocation because I’m young and highly tolerant to volatility. That said, I see precisely zero benefit in attempting to pick stocks or pick winning active funds. I’m entirely indexed.

  6. kenyantykoon says:

    i am more the aggressive investor and while there are times that you get hurt, there are more times that you gain better returns than most of the risk averse investors. it all depends on how you pick your stocks and your advisors and many other issues. even the risk averse investors get hurt many times

  7. For my retirement money, I am super conservative with 90% of my funds in a guaranteed 4.2% yielding CD. It’s low, I know, but I enjoy the security, and it generates over $20,000 in interest income a year.

    I generally like to use the other 10% of my money and go SUPER high risk and go on 1-3X leverage and trade the market. Even if i blow up, it’s only 10% of savings.

    If you’re under 35, just go for it. Once you reach a certain amount of savings, you can go conservative and live off the income.

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