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Risk Profiling for Long-Term Investing



The Ontario Securities Commission commissioned a study called Current Practices for Risk Profiling in Canada And Review of Global Best Practices.

The document is quite complex, but it did a very good job defining how you might interact with risk. So let's review the risk profiling definitions in context of long-term investing.

Study Finding #4 - Risk Capacity:

An individual’s ability to endure a potential financial loss. The extent to which a person has the financial ability to take on the risk.

How does this impact you?

When you begin long-term investing, you are basically saying to yourself: “The money I set aside for long-term investing is money I will not require for at least ten years.” If you fall short one month, or your roof leaks, or your car needs a repair, your Current Self must promise your Future Self that you will not touch the money you have set aside for long-term investing. Instead, your Current Self will tap into your savings account, line of credit, parents, or whomever, for a short-term loan.

Do not put yourself in a position of having to sell your long-term investments to meet a short-term obligation, as you then risk being forced to sell when the market is down!

Study Finding #6 - Risk Perception:

This perception can be heavily influenced by the media and/or a lack of understanding of the risks. The influence of risk perception and ambiguity aversion may be reduced by greater financial literacy, education and/or experience.

How does this impact you?

This is the great debate – perception versus reality! When, not if, the market has a big drop, you have to manage your emotions. The first step in being able to do this, is to educate yourself about investing, which, by the way, is exactly what you are doing now! In long-term investing, market drops can be seen as mere volatility, and therefore buying opportunities, i.e., the shoes you wanted are finally on sale!

Study Finding #8 - Risk Preference:

An individual uses a combination of subjective and objective cognitive evaluations to generate their risk preference. There may not always be justification for the individual’s feelings regarding their preferences.

How does this impact you?

You know that due to inflation, not investing is not an option. You know that if you stop working for whatever reason, you will need more money than you have now. You know you need to get your money to grow to meet your investment objectives. Soooooo,  you know that some risk is unavoidable.

The amount of risk and return you need to take on should be calculated (the Rule of 72 helps here). Generally if you need higher returns to meet your objectives, you will need to take on more risk, i.e., more equities.

Both the target return and the required risk you take on should become your risk preference. But sticking to your plan means you will need to use your brain and investing education to overcome your emotions. That means resisting the urge to sell when the market drops (due to fear), and resisting the urge buy more of a stock that is rising quickly (due to greed). This discipline is hard work, but will lead to your long-term investing success.