Whether you are a first-time investor or are diversifying your portfolio, knowing the amount of risk you can withstand for your investment is important. By undergoing an investment risk assessment, your financial advisor can better understand your goals and outlook and help arrive at sound financial decisions. This process is typically done by answering a set of questions that aim to determine your risk attitude, tolerance, capacity, and requirement.
Concepts related to risk assessment
To better understand how beneficial an investment risk assessment is, it is imperative to know the following concepts.
- Risk attitude. This element refers to an investor’s understanding of the risks that could possibly affect his or her investment/s in both the short and long run. The whole picture of someone’s risk attitude is better painted when it is assessed at the outset and after other elements like risk capacity is identified throughout the whole investment risk assessment process.
- Risk tolerance. Tolerance in the world of investment refers to a client’s mental and emotional capacity to endure and handle an investment loss or a volatility in the amount of his/her investment’s returns. It is a subjective measurement.
- Risk capacity. Often interchanged with risk tolerance, risk capacity is the actual or quantification of an investor’s ability to take in a possible loss — whether it’s a significantly huge one or not. As how the Economic Times put it, tolerance is the risk someone “might want to take” while capacity is what he or she “can [actually] take.”
- Risk requirement. In order to achieve a certain amount of return or hit a particular investment objective, a certain amount of risk is needed. When assessing investment risks, an advisor must be able to determine how much risk should be taken or is required before an investment goal is achieved.
The benefits of risk assessment.
Financial advisors and risk managers use an investment risk profile to get a good grasp of what their clients want and how capable they are of withstanding any possible loss. By conducting a thorough risk assessment, they will be able to direct their customers’ funds into the most appropriate channels, and ultimately assist them in hitting their financial goals within their desired timeframe.
With tools like an investment risk tolerance questionnaire, the whole investment process will be much more effective and efficient. Furthermore, risk assessment will also help financial experts to foster trust among their clients. By knowing their clients’ risk ratings, they can develop financial plans that are attuned to what their clients want. And they can use it as a documented proof or basis for future investments.
