When developing traditional diversified investment portfolios, there is a direct trade-off between risk and return; in essence, the greater the risk you are prepared to take, the higher the potential returns.

Defensive asset classes, such as cash and fixed interest, are far less volatile than growth assets such as shares and property, but also have much lower long-term average returns. When developing an investment portfolio, the greater exposure to growth assets, the higher risk and the higher the potential return.

The most important tool a financial planner has to manage the appropriate risk for each client is using what we call risk profiles (also referred to as investment profiles). We assess each client based on the time horizon of their investment, the purpose and goals of the investment and the individuals’ natural tolerances to risk. Each client is categorised to match a risk profile based on these factors.

Each profile is associated with a level of volatility that research has shown is acceptable to a person of that profile. The mix of growth and defensive assets is selected to perform within that volatility tolerance.

The most important factor in determining risk profile is the length of the investment. Short investment horizons require defensive portfolios. The reason for this is, statistically speaking, the longer the investment horizon, the more likely the portfolio will perform in line with the long-term average. In statistical terminology this is known as regression to the mean.  In simple terms, if an aggressive portfolio has a negative period, you require time to recover.  Conversely, long-term investments such as superannuation traditionally have more aggressive investment portfolios as the short-term performance is more or less irrelevant and the long-term higher levels of growth are more important.

It is also important to match the needs of the investment to the risk profile. My guiding principal here is to take no more risk than necessary. For instance, if your investment is to provide you income in retirement, you have high levels of assets in relation to your needs, and you will comfortably meet your needs with a defensive portfolio, why take more risk than you need to?

The third determining factor is a client’s natural aversion to risk. At times this is more art than science. Knowledge and experience in investing, combined with the client’s nature are what we consider. I use a questionnaire that assigns points to give an overall risk assessment.

Once we have looked at the 3 determining factors, whichever of these leads to the most conservative outcome is the profile we implement.  I look at this as a, we are only as strong as our weakest link, type decision.

The investment portfolio will then have exposure to growth and defensive assets that will have risks and returns suitable to the client’s circumstances.