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If you’re a property owner, investor or looking to get into the market The Rentvesting Podcast will help cut through the hype, look at the facts and draw on decades of experience to help you make smarter property decisions.

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Jul 8, 2017

On this week's episode of the Rentvesting Podcast we're talking about risk profiling. This episode is based on a question from Chris, looking at a bird's eye view of how you can be thinking of investing. We're breaking down why people make decisions and what risk profiling is based on. The question was around where someone should really be investing, as opposed to where someone does invest.

 

We'll run through what determines that individual preference along with what it should be

A lot of people who have lost money in the share market are now moving to property. This is based on psychology, if you're risk tolerant and don't mind things like gambling, running with scissors, swimming after you've just eaten - these sorts of people are considered risk tolerant. The other

On the other side of this are those considered risk adverse, they don't like taking risks in life.

Based on that fact, that starts to determine where, if they're looking to invest, they do.

If someone is risk tolerant they might go for penny shares where those companies could go up or down a lot. While someone who is risk averse might just keep all their money in cash.

 

What's the risk reward concept? There's low risk like cash, then there a high risk.

In financial markets or investment, risk isn't like everyday risk. Risk is considered through volatility. The risk-return equation says the higher the volatility you accept, the more movement that can occur, the higher your return should be.

For instance cash, cash can't lose value unless hyperinflation occurs. Cash doesn't move up and down, it will get you different interest rates but as you go down the chain of assets that have higher growth components because they go up and down, they now have volatility. The greater they go up, the greater they can go down.

If we break it down on the chain as far as what's the least and most volatile:

  • Bonds have a slight volatility, but generally, they're more an income asset.
  • Property and shares, when they have growth components to them - you can break it down to high or low growth depending on the area. You can buy in blue chip suburbs where the yield might be lower, but high-risk suburbs like mining towns could have high yield but also could drop and then you could be at risk.
  • As for companies, the banks don't move so much but smaller companies have more risk involved and that volatility can be at 80% a day.

 

How do people determine when they invest in that risk profile?

Generally, people just determine it on their own, they invest in what they feel is right for them. Sometimes it's easy to miss the point though and what you're trying to achieve.

Individual needs + psychology = risk profile.

  • Someone who is young and can handle the risk could go for property, because they have time to invest in a long-term investment.
  • While someone who is defensive in retirement should go for 30% growth and 70% defensive.

 

Are there any one size fits all rules?

Not really, it depends on the individual. I've seen some 20-year-olds who don't want to invest in any shares and they think they're too risky. Then I've seen some individuals in their 70's have invested in their shares all their life and love the up and down changes of it. While even though they need more defensive assets at that time.

Although there might be broad profiling depending on the age and time you're at in your life, it really depends on the person.

For myself, when I try to figure out where funds should be invested the first thing we look at is their individual means and how long they want to be investing the money for.

  • If it's for a home deposit that's 2 - 4 years and those funds shouldn't be invested as it's too short term.
  • But if it's for long term 30 - 40 years that can allow a lot of growth, especially if there are regular investments, it's better to split out the investments over time.

 

What are some questions on how you determine a risk profile?

Return requirements

Return requirements mean that planning and forecasting are required in order to get 8% return per annum. So working back from how much you need in your super, we look at how much you need as an underlying return. If you cut out growth from the equation:

Income + Growth = Return.

You've halved a lot of the equation and if you're defensively invested, you'll be getting income from cash and bonds and a little bit of growth. But if you get that solely, you're likely to get a lower percent return than if you've got more growth allocation over the long term.

So that's the first one looking at return requirements.

How much to invest

If you've got a lot to invest and more money to diversify, that can often allow for a bit more risk to be taken on. Just generally, we ask them what their reaction to case scenarios would look like. For example, if your investment goes down by 50% how would you react? What's the max level of volatility you want to accept in a portfolio? This is looking at their psychology of how tolerant they are.

This is looking at their psychology of how tolerant they are.

Figure out what sort of needs you're after.

We also test their understanding with questions like - say the portfolio does drop by 25% how would you react? Would you invest more? So that one helps determine a lot of their knowledge around investment

So that one helps determine a lot of their knowledge around investment and volatility. It's about re-educating, as volatility occurs, so the best thing to do is not to sell, because selling when it goes down guarantees you will lose money.

If a share goes from 100 to 50, it then needs to go up by 100% to go back where it was. If you invest at that point, then your upwards return isn't that great. So if you added another 50, then any additional growth after is just a plus.

In summary, shares are the highest risk - between shares, property, fixed interest and cash.

 

Case Study

Looking at case studies at a high level, if Bob is a young investor and has only invested once (30 years old), what is the portfolio for someone who is a bit risk averse but wants to grow?

As this person has probably been burnt by investments before, they probably will try and avoid it. For this individual, it would be about reeducating them. If you're in your 20's and your investment is in super, let's have a look at the difference between keeping your funds in cash or taking on additional risk over a 30 year period.

First of all, don't sell! If you have a surplus of cash or you manage them wisely, they shouldn't drop that much.

Long term, the market does recover.

 

On the other side, Sarah loves to gamble, she's a bit older, the late 50's and has a decent amount of money. Is it bad for her to go high growth, high risk?

It's up to her. If she's about to retire, what will she live on?

If Sarah has a decent amount of money to retire on and draw an income, it's probably better for her to be more defensive. If she's 100% invested in shares, then 40% of their value could go down.

 

Key takeaways

  • Risk profiling is based on your individual needs and not what your friends are doing or what the market does.
  • It's based on your individual profile - answering the above questions, understanding what you can handle if it goes up or down.
  • Changing the perception of letting external things determine where you invest and looking at what is the right thing for you towards your long term goal.

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