When it comes to successful real estate investment, knowing one’s risk profile is one of the foundational ingredients in formulating a successful property investment strategy.
A person’s risk profile can be defined as the set of factors that make up the person’s ability and willingness to take on risk. It is important to understand that an individual’s risk profile is different from their personality.
A financial risk is simply the likelihood of an event that causes a loss on an investment.
Successful property investment education includes the understanding of a property investor’s optimum level of financial risks.
A risk profile assessment is the first step to discovering this ideal level of financial risk-taking.
There are three factors that determine a person’s risk profile?
A person’s risk profile assessment is made up of three parts. These parts are evaluated by a set of questions that can be categorised into a person’s:
• Risk Tolerance.
• Risk Capacity.
• Risk Appetite.
When a property investment coach formulates a winning property investment strategy, they use the three parts that make up a risk profile by finding a property investor’s sweet spot. This process can be illustrated by the diagram below.
What is Risk Tolerance
Individual risk tolerance is the amount of risk that a property investor is comfortable taking or the degree of uncertainty that he or she is able to manage. Risk tolerance frequently varies with age, income, and financial goals.
Risk profile assessments often use quantitative measures to assess a real estate investor’s risk tolerance. These measures aim to assess the level at which the individual can invest while still being able to sleep at night without worrying about the risk of a loss. For example:
Rate your level of comfort on a scale of 1 to 10, 10 being highest, and 1 being lowest for the following question:
I am comfortable handling a 20% drop in the value of my $500,000 investment property.
What is Risk Capacity
Unlike Risk Tolerance and Risk Appetite, Risk Capacity is the amount of risk a property investor is able to withstand without running into financial trouble.
To determine the Risk Capacity of any individual, many factors need to take into consideration, such as:
• Education, income (current and future),
• Financial security,
• Personality type, to name a few factors.
Oftentimes, risk capacity is highly correlated with a property investor’s financial life cycle. This is why many property investment mentors seek out risk profile assessments that take a holistic approach to risk profiling by evaluating a real estate investor’s risk tolerance, risk capacity, and risk appetite when determining what stage the individual is at in their financial life cycle.
What is Risk Appetite
Risk appetite is a qualitative measure of a real estate investor’s willingness to accept risk to achieve his or her financial goals. Whilst very similar to an individual’s risk tolerance, there is a difference. The difference can be explained by an investor’s attitude towards risk vs an investor’s measurable level of risk-taking.
Recalling the example of a risk profile question aimed at measuring a property investor’s risk tolerance, we now illustrate how risk profile assessments measure an individual’s risk appetite: Choose
Choose the statement that applies most to you when it comes to making investment decisions and your investments in general:
A: I am always concerned about possible losses.
B: I am somewhat concerned about possible losses.
C: I usually consider possible gains.
D: I always consider possible gains.
Putting it all together: Risk Tolerance vs Capacity vs Appetite
A really good property investment education provider would be able to explain, in layman’s terms, these three elements of a property investor’s risk profile clearly and concisely. Illustrations, stories, whiteboarding, and diagrams are common ways to test one’s understanding of these overlapping concepts. To this end, we give an example of a great explanation.
A person’s risk tolerance is a measure of the level of risk they are prepared to take, for example, “I am willing to accept a 20% loss on a property investment that’s been proven to yield 50% returns over the long run”.
An individual’s risk capacity can be measured by the maximum loss they are able to take before running into financial trouble. In this example, assume the investor’s risk capacity is $100,000.
Using this same individual, imagine that they usually consider possible gains when it comes to property investments.
Putting this all together, a real estate investment coach who has performed a risk profile assessment on this example investor will know that he or she can coach the mentee on property investments valued up to $500,000 (factoring in a risk tolerance of 20% and a risk capacity of $100,000). They can pivot their coaching to properties that have the potential for higher than normal capital gains but are also more volatile than blue-chip suburbs.
What is Risk Profiling?
Risk profiling is a process of assessing an individual’s optimum levels of investment or financial risk.
Understanding your Risk Profile
Any Investments come with a risk. And taking risks is not a bad thing, provided you have managed the risk with the care and due diligence required.
This is why Strategic Investors have created a risk profile assessment questionnaire to help you make sure that your property investment risks are managed in such a way that they do not impact your life.
What are the benefits of knowing your risk profile?
Undertaking a risk profile assessment helps property investors and their team of advisors (including, but not limited to, accountants, lawyers, and property investment mentors) understand themselves better so that a successful property investment strategy can be tailored to their individual needs, circumstances, and financial goals.
Some key benefits of this assessment include:
A Self Awareness of one’s Risk Tolerance
You are raising your risk awareness and understanding of your risk profile of tolerance, appetite, and capacity for risk. It will undoubtedly put you in good stead in making any future financial decision and help you avoid costly mistakes. Just knowing about your profile will provide a level of confidence.
Your team will understand your Risk profile
The risk assessment will also provide your financial advisor, accountant, strategist, and property investment mentor, with insightful and valuable information about how you feel about personal risk. It will provide a clearer view of the relationship between the risk types and how you feel and are capable of managing them. With the information, your property investment team will be able to provide financial advice based on your profile rather than on guesswork or bias. It is intended to remove any negative impact on you emotionally or financially.
Supporting Sustained, Conscious, And informed risk-taking
By specifying just how much risk a property investor would like to take, an educated and informed set of investment options can be formulated to suit the individual’s risk profile. This ensures consistency, which is essential in the investment world, where the wonder of compound returns is demonstrated time and time again.
Consistency in Risk Taking and its Mitigation Strategies
Your risk appetite connects broadly to just how much risk you are willing to take or desirable. It makes it possible to design mitigation strategies to address risks when they occur or are about to happen.
Assisting risk decision-making as well as grasping opportunities
Risk profile assessments help provide the framework for decision-making. This allows a real estate investor and his or her team to execute their tailored winning strategy with minimal lag times. Costly mistakes are also avoided, for example, investing in a risky asset that is beyond the risk appetite of a property investor, leading to additional costs of liquidating the asset and other opportunity costs.
Structuring Conversation on Risk Taking
Remember the example of a good explanation of the three parts of a risk profile. In the same way, the real estate investment coach was able to advise on an appropriate set of investment opportunities, an investor can have a meaningful discussion with his or her team about risk-taking.
Calibrating Risk Evaluation Criteria Description.
Each risk is not always black or white, and there are often many grey shades. The clearer the risk appetite description, the easier it is to create a range of mitigation strategies for the severity level that often accompanies any form of investment.
The timeliness of responding to a risk occurrence can determine the severity of the financial impact.
Investor Profile Types
When it comes to choosing what to invest in, having a guide of your profile will assist you and your advisors in approaching your investment portfolio. Risk profiles will differ from person to person.
Many factors influence your risk profile, including personality type, goals, financial situation, and individual circumstances. Your risk profile will also, from time to time, depend on your stage of life and circumstances.
The model we have used is not foolproof, and it is intended to give you and your advisors some guidance on your tendency and capability.
Understanding Risk Profiling Assessment Questionnaires and their limitations
Risk profiling for any individual is a very complex activity. There are so many variables to consider. An example that illustrates how complex an assessment can be, consider two scenarios of the same individual:
1. You may be doing the survey late at night after a bad day at work, and you are not in the best of moods, your completion would be tainted due to your mood.
2. On the other hand, if you had just had a few good months on the stock market with all or shared performing well and had big dividends paid out. Performing the assessment during this time would yield different results.
Try our risk profile questionnaire to find out more about your risk profile.
The risk profile assessment should be used as a guide only along with other known factors. We have provided a non-exhaustive list of the disadvantages and advantages of undergoing this process in the table below.