What is the risk tolerance profile in finance and how it is assessed

Elizabeth Smith

Investors have different behaviors and approaches to financial assets. First of all, there are various types of people based on their risk tolerance. There are investors who can tolerate a high degree of uncertainty and those who seek security. Therefore, when deciding to invest and build your own portfolio, it is essential to be aware of your risk tolerance.

What is the risk profile?

Understanding what your investor profile is, starting from your risk tolerance, is the first step in building a balanced investment portfolio. Therefore, some main points need to be defined:

  • understand your risk profile;
  • how much capital can be allocated to the investment;
  • what is the time horizon.

Once these aspects have been defined, you can then develop the right asset allocation of your portfolio, for example understanding how much percentage of capital to allocate to shares, bonds or fintech investments.

To understand your risk profile, you generally need to ask yourself a series of questions. Or, better yet, a financial advisor should ask the investor such questions:

  • The value of financial products fluctuates: how many negative fluctuations are you willing to tolerate? How long?;
  • How much do you aim to earn (investment objectives)? In this case we must remember that the higher the risk the greater the potential return. Conversely, the lower the risk the lower the possible return;
  • How anxious are you? In fact, the psychological profile is fundamental. Overly emotional people could fall into panic-selling, i.e. selling at a loss as soon as there is a negative swing.

The risk profile can change, even clearly, from person to person. This is an essential factor in being able to provide independent and adequate financial advice.

Age and risk profile

Does age affect the risk profile? Absolutely yes. Younger investors tend to have a higher risk profile. In fact they can take on greater risks as they have a very long-term time horizon.

On the contrary, investors of retirement age usually have lower tolerance for risk. In this case the aim is to build a portfolio with a short investment time horizon, with reduced volatility to mitigate the danger of a sudden drop in value.

Mifid 2 and risk profile from 1 to 7

Mifid 2 is a European directive that regulates the management and subscription methods of investment products. The main objective is to protect savers. The regulations are valid in European Union countries, plus Iceland, Liechtenstein and Norway.

The main innovations introduced by Mifid 2 concern information aimed at savers. First of all, product costs must be transparent, indicating both the aggregate cost and that of the individual components.

Furthermore, every traditional financial product – with the exception of some alternative and innovative finance products which are not subject to Mifid – must be accompanied by a summary sheet, the Kid.

The expected return must also be indicated on the information pages, highlighting the most probable market scenarios. In terms of controls, the market supervisory authorities – ESMA is the European one, the national ones are Consob and the Bank of Italy – can suspend the sale of financial instruments deemed unclear.

Furthermore, financial products must have some sort of label, which must indicate:

  • what type of investor they are targeting;
  • risk profile focus;
  • the advisor must clearly state whether he is independent or whether he has a particular interest in the sale of the proposed financial instrument.

Read also: The herd effect in finance: what it is and how it works

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