RISK PROFILING

The investment objective favoured by private investors is to achieve the highest possible return for the least possible risk. And depending on whether equity markets have been rising or falling, investors tend to place more emphasis on the return or the risk side of coin. To avoid future disappointment, great care must be taken at the risk profiling stage of the investment process.

Investor objectives

Investors typically have a combination of three aims: preservation of wealth; provision of income; and capital growth. These objectives are not mutually exclusive and the weightings are rarely constant. An understanding of the dynamics of these three variables is essential if a suitable investment objective is to be crafted.

Multiple time horizons

The concept of investment risk only has validity in the context of a defined time horizon. But whilst an investor might have a time horizon of several years or even decades, investment managers report on a monthly or quarterly basis. Unless dealt with explicitly, this mis-match almost inevitably leads to unnecessary angst.

Risk of loss

Most investors equate risk with the likelihood of suffering capital loss. Often measured in monthly or annual terms, risk of loss is in essence a function of the unpredictability of returns over time. To achieve above cash returns over the long term, risk needs to be embraced rather than avoided, within the comfort zone of the investor.

Risk of disappointment

This type of risk relates to the style of an investment manager. Contrast an index tracker with a concentrated 20 stock portfolio. The tracker follows the index up and down, month-by-month. The concentrated portfolio will probably behave very differently to the index. Understanding the style of each manager is an essential part of assessing manager performance.