Financial risk profile: what is it and what it depends on

Elizabeth Smith

7 May 2023

When investing, it is good to know your financial risk profile. In fact, each profile corresponds to a different asset allocation.

There is no investment portfolio suitable for everyone. Every investor has different attitudes toward risk. This is the so-called risk profile. Some are willing to endure more uncertainty for higher returns, while others prefer lower returns but more security.

That is why, when investing, it is good to know your risk appetite and thus your risk profile. Each profile corresponds to a different asset allocation.

Table of Contents

What is the risk profile?

Identifying the risk profile is the first step in defining a suitable investment portfolio for the investor, along with the amount to be invested and the time horizon. Only with these three elements can you identify a proper composition of your portfolio.

The identification of the risk profile usually takes place through a series of questions to understand how much one is willing to risk. Thus, the goal is to understand how one would react if one saw a loss on one’s investment.

One’s ability and willingness to take risks can vary depending on several factors. One such factor, for example, is age.

Younger investors tend to have a longer time horizon for investing and theoretically can take on more risk than a retired person. Who instead invests in the short term and prefers to reduce the risk of a sudden loss on their investment, even at the expense of higher returns.

How is the risk profile calculated?

An investor’s risk profile can belong to one of four levels.

low risk tolerance: one can sustain losses of up to 5 percent per year. In this case, the most suitable instruments are money market funds, certificates of deposit, and short-term bonds;

moderate risk tolerance: losses between 6% and 15% per year can be sustained. Here we have, for example, portfolios diversified between stocks of solid companies and in mature sectors, and medium- to long-term bonds;

high risk tolerance: losses can be between 16% and 25% per year. One can therefore also look at stock market investments in more volatile sectors such as startups or emerging industries;

very high risk tolerance: which also involves losses of more than 25 percent per year. In this case, you also invest in international currencies, cryptocurrencies, and other volatile but very profitable assets.

Why is it important to know your risk profile?

The level of risk one is able to bear should be considered before making any investment. Confronting too much risk, in fact, can lead to negative results.

It happens, for example, when, after a market crash, the panic-stricken investor sells in bursts without reasoning, ending up collecting even greater losses.