Whenever we think about investment, what is the first thing that comes to our mind? Returns, isn’t it? Generally, we think about how much returns we can make from investing. But do you know that it is the wrong approach to thinking about investing?
Before you start thinking about how much returns you can make from investing, you should think about what are the right kind of investments for you. But how do you know what is the right kind of investment for you?
Risk profile assessment
To understand the kind of investments that are suited for you, you should always undergo a risk profile analysis.
Risk profile analysis, or risk profiling, helps you make your investing approach more holistic. It takes into account your risk tolerance, investment needs/objectives and current life stage to assess suitable investments for you.
1. Risk tolerance
The first part of a risk profiling assessment is understanding your personal risk tolerance.
The question of how much risk we are willing to take differs for each of us. A young single man who has just started his career might have a very different risk tolerance than a middle-aged person with a family and a housing loan to repay. Furthermore, even between you and your spouse, you might have different risk tolerances, despite sharing the same life stage and similar investment objectives.
Luckily for us, experts have devised a series of short questions that can help us to better determine our personal risk tolerance. One such questionnaire can be found from Central Provident Fund’s (CPF) website here. By answering the five questions on risk tolerance, you will be able to learn how comfortable you are with taking risks in your investing.
The CPF risk tolerance questionnaire has a possible range of scores from 5 to 45. Higher scores are associated with the level of comfort you have with taking greater risk in your investments to achieve greater returns over the long-term.
For those with a high risk tolerance, you would be more comfortable with holding a greater proportion of risky assets in your portfolio. This includes assets like stocks or even derivatives. In contrast, if you have a low risk tolerance, you would be more comfortable holding safe assets like bonds or gold in your portfolio.
2. Investment objectives
The second thing you need to figure out is your investment objective. For example, is it to accumulate funds for your retirement or for your children’s education? How much money do you need and when do you need it?
This might sound common sense but you will be surprised how many people often do not know their investment objective. Without having a clear idea of your investment objective, you might fall into the risk of choosing investments that do not suit your objective.
Most investment objectives can be classified into the following three objectives:
a. Preservation of capital
If you have already reached your savings goals, your investment objective may be capital preservation to protect what you have saved.
b. Capital appreciation
If you have just started building your retirement savings, your investment objective will likely be to appreciate your capital.
c. Building passive income
If you have retired and need to have easy access to your retirement savings, your investment objective could be to ensure high liquidity investments. You might also want your capital to generate passive income.
If you are wondering how to use your CPF savings to invest, here’s a quick guide to get you started.
3. Investment Constraints
When doing a risk profile assessment, you also need to consider your personal investment constraints. This will ensure that your investment constraint doesn’t adversely affect your investment performance.
Liquidity constraint is a common investment constraint that might affect you. Liquidity constraint is your need for cash at a particular time within your investment period. For example, you might be due for a home down payment of S$50k in one year’s time. If you didn’t consider your liquidity constraint and invested in stocks, you might be forced to sell your investments in a bad market. This will result in your eventual inability to meet your liability.
The first step to making good investment decisions: Understanding your risk profile
To take a risk profiling test, you can either find them online or through financial institutions in your neighbourhood.
Under the watchful eye of the Monetary Authority of Singapore (MAS), it is mandatory for financial institutions to do a risk profiling for you. Financial institutions must complete a risk profile analysis before they can introduce any financial products to you. You can leverage their service to help you understand your risk profile. You will then be able to find the investments that are suited for you.
Psst. Do also stay tuned for our next article on “How To Test Your Risk Appetite”.