There's no need to take a lot of investment risks

I believe that most people have a very similar tolerance for investment risk.  Most people are comfortable achieving a long-term annual return of 7% to 10% if the risk of losing money is very low. In short, I think most people have a low appetite for risk – they prefer to take as little risk as possible and invest in a “sure thing” if the return will be enough for them to meet their goals. 

What is a risk profile

Risk is the probability of not achieving your targeted investment returns. This might happen in two ways. 

Firstly, the investment might end up being a dud with little prospects of ever delivering the returns you desire i.e., an investment mistake. 

Secondly, you might not achieve your returns temporarily, due to intermittent volatility. For example, if you invested in the Australian share market in May 2021, your return just over one year later is zero, as over that time, the market risen, fallen, and subsequently recovered back to May 2021 levels (ignoring dividend income). But this volatility is almost certainly temporary. We know that over multiyear periods (e.g., a decade or longer), the market has always trended higher. 

Most people are only concerned by the first risk because they know volatility is normal and are happy to endure it if they will be rewarded adequately in the long run. 

That said, some people, albeit a minority, have a low tolerance for intermittent volatility. 

How do you measure your risk profile 

The traditional way to measure risk tolerance is by asking a series of hypothetical questions to measure your comfort/discomfort with experiencing volatility and investment losses. This questionnaire is a good example, which we use in our practice (it’s based on this paper). 

However, I am skeptical that these questionnaires provide reliable information. It’s one thing to predict how you’d feel if your investments fell by 30% of value, but until your experience it, you don’t know for sure. We know that humans have a strong cognitive bias for loss aversion – the pain of losing is psychologically twice as powerful as the pleasure of gaining. 

95% of people have the same profile 

I describe most people’s risk tolerance below (including my own): 

I work hard for my money, so I don’t want to take high risks

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