Pre-script: I’m reposting a series of posts from a few years back on Unit Trusts. There are four. This is the second.
The key question when it comes to assessing your risk tolerance: “Why are you making the effort of putting money aside anyway?”
Some potential answers:
- Because I’d like to get rich;
- Because I’d like to be able to retire with it;
- Because I’m saving up for something else.
Your answer will determine the type of return that you’d like to get from your savings. And in a perfect world, that would be enough.
Unfortunately, that’s only half of the answer – because the other half is the level of risk that you’re willing/able/prepared to accept in order to earn that return.
The Other Half Of The Answer
Some factors that play an important role in your self-risk assessment:
- Age: if you’re young, and you start saving – then booyah! Life be awesome, and you can afford to take risks and lose some money. And if you’re older, you’ll want to keep what you have – so fewer risks, thanks. Although, of course, if you only start saving when you’re about to retire, then it’s possible that you won’t be able to afford not to take risks. But that’s okay – because if you only get round to it then, you’re quite clearly a risk-driven individual anyway*.
*Either that, or very foolish. But if you are that foolish – then that may also count in your favour, as long as you also take foolish risks…
- Wealth level: if you’re rich, you can generally afford to take more risks – but you may not want to. If you’re less rich, then maybe you’ll want to take more risks to get richer; or maybe you’ll just want to preserve what you have already.
- Personality Type: go and take the Jung Topology online test, and if your four letter score has an “F” in it – then you can forget taking big risks. If it has a “T”, you can think about it. I’m just saying that risk-taking is not for the paranoid – even if it’s calculated.
- Occupation: you want to aim for balance. If you’ve got a stable job, then ideally, you should take risks with your investments. And if you’re entrepreneurial – then your investments should be safe enough to carry you through those times when your entrepreneurship has led you to a hard place.
- Time Horizon: if you’ve got some money that you’re putting aside for a house deposit, then you DON’T want to be putting that at risk. If, on the other hand, you’re putting aside money for the next 40 years – well then you should close your eyes and put it into something that with a real promise of return.
Here’s a rough scale:
If you are looking for a quick way to find out just how risk tolerant you are, here’s a link to a free online test. I scored 39, which suggests that I regularly attempt to leap off buildings “just to see” if I can make it to the other side. On the other hand – I’m young, unmarried, and unencumbered by debt. So it does make some sense. And here is another, more thorough test – which gives you a much fuller report at the end. On this one, I scored 92. Which makes me think that I already know what they’re asking for, so I’m trying to jimmy the score upwards.
So what now?
Based on the combination of your risk tolerance and your desired return, you’ll now be able to decide what asset class of unit trust you should be looking at. Here’s a rough guide (again) from low-risk assets at the bottom, all the way through to outright betting (derivatives) at the top:
Disclaimer: this really is a rough guide*. There are times where the bond market will be riskier than equities (like if you’re buying junk bonds from Greece). And sometimes the global market will have less risk than the local market – but you are exposed to currency risk, which can easily push the risk up really high if you’re living in a country with a highly volatile exchange rate (like South Africa). I’ve also left out commodities like hogs and corn – because I think that these fall out of the usual unit trust offerings (especially in SA – where the majority of my readers live).
*Derivatives, for example, were invented to reduce risk, not create it. If you own a car and have an insurance policy on it, then the car would be the asset and the policy is the derivative – and by having it, you cover the risk of not being able to replace the car if you have an accident (ie. you have less risk). But if you just take out the insurance policy (on, say, your friend’s car) – then it’s high risk for you, because you’re just paying premiums that may never come to anything. But if he crashes, then it’s good times for you, because you get a new car!
And for the record: Balanced, Stable and Optimal portfolios are mixes of the main asset classes (equities, bonds and money market instruments) – just with different weightings to achieve different risk profiles.
But regardless, it helps to have some idea of where you might be placed. For example, I simply cannot abide the idea of investing in the money market*. It’s just not for me – so I won’t waste my time looking at the unit trusts that offer MM investments (and I would waste time – there are almost 1,000 unit trusts on offer in SA alone – just no ways I can look at all of them!).
*The money market is for very short term debt. So short-term treasury bills (the government version) and Commercial Paper (the private business version) – where the government and/or corporates borrow money from investors for only a few months. Usually at very low rates of interest – because the repayment period is so short!
The next post…
Having self-assessed one’s risk, and with a rough idea of what asset class you should be investing in, you can now start looking for the right unit trust. And here’s where you can get excited about fees and investment styles and historic performance. Unfortunately, most people start with those, and then work backwards. And even if it does work out sometimes, it’s not ideal.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.