The difference between risk perception and risk profile

12th July 2011

Risk is a very important concept in Financial Planning, because it has a huge influence on the decisions that we make around money.

In order to make good decisions we need to understand that there is a difference between risk perception and risk profile.

Risk Perception

Our perception of risk changes all the time. It is an emotional response to things like stock market movements and news reports. For example, if share prices have been going up for some time we perceive them to be a less risky investment than if they have been falling for some time. This leads to poor decision making – investors tend to buy high, sell low, lose money and feel very bad about their investment decisions.

Risk Profile

There are three important aspects to your risk profile:

  • Risk Tolerance – how much risk are you prepared to take?
    We all know that Stock-markets offer a roller-coaster ride to investors – particularly over shorter time periods. Risk Tolerance is a measure of how bumpy it can get before you start to feel uncomfortable. Your risk tolerance can be measured and generally changes very little over time.
  • Risk capacity – how much risk can you afford to take?
    This is a measure of your ability to sustain investment losses and still achieve your financial objectives. Your risk capacity is influenced by a number of factors, including timescale (which will allow you to recover from a short-term fall in the market), how much money you have and how much income you need.
  • Risk required – how much risk do you need to take?
    This is the amount of risk you need to run to achieve the returns required to meet your goals.

A comprehensive Financial Plan will include your risk profile, which means that you will have the tools to support a good decision making process. You will have a much better understanding of what you need your money to do for you and will therefore feel good about your investment decisions.

If you would like to discuss your specific circumstances, please get in touch.