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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.
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.
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:
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.
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.
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.
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.
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