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What Is a Risk Profile?
A risk profile is an evaluation of an individual's willingness and ability to take risks. It can also refer to the threats to which an organization is exposed. A risk profile is important for determining a proper investment asset allocation for a portfolio. Organizations use a risk profile as a way to mitigate potential risks and threats.
Key Takeaways
- A risk profile is an analysis of how willing and able an individual is to take on risk.
- A risk profile helps set the allocation of investment assets in a portfolio.
- A risk profile can be deployed by an organization to manage risks and threats.
Risk Profiles for Individuals
The risk profile for an individual determines that person's willingness and ability to take on risk. (Risk, in this sense, refers to portfolio risk.)
The ability to take risks is evaluated through a review of an individual's assets and liabilities. An individual with many assets and few liabilities has a high ability to take on risk, whereas an individual with few assets and many liabilities has a low ability to take on risk.
An individual with a well-funded retirement account, sufficient emergency savings and insurance coverage, and additional savings and investments (with no mortgage or personal loans) likely has a high ability to take on risk. An individual who lacks some of these assets (an emergency fund, for example) and has too many liabilities would be less able to take on risk.
Willingness and ability to take on risk may not always match up, of course. For example, someone with many assets and few liabilities may be capable of taking on risk, but may also be quite conservative by nature and simply not want to take on risk. This will affect how the portfolio is constructed.
Risk can be thought of as the trade-off between earning a higher return or having a lower chance of losing money in a portfolio.
Risk Profiles for Companies
A risk profile can also illustrate the risks and threats faced by an organization. It may include the probability of negative effects and the potential costs and level of disruption for each risk.
It is in a company's best interest to be proactive when it comes to its risk management systems. Some risks can be minimized if they are properly accounted for. Companies often create a compliance division, which helps ensure that the organization and its employees are following regulatory and ethical processes. Many companies hire independent auditors to help discover any risks so that they can be properly addressed before they become external issues.
Failing to minimize risk can lead to negative consequences. For example, if a pharmaceutical company doesn't properly test its new treatment via the proper channels, it may harm the public and lead to legal and monetary damages. Failing to minimize risk could also leave the company exposed to a falling stock price, lower revenues, a negative public image, and potential bankruptcy.
What Is Meant By Your Own Risk Profile?
A risk profile identifies the level of risk an individual is prepared and able to accept. A company's risk profile attempts to determine how a willingness or aversion to take on risk will affect an overall decision-making strategy. In some cases, there is arguably too much willingness to take on risk. In others, there's arguably too little.
What Is a Balanced Risk Profile?
A balanced risk profile typically has half of its portfolio invested in conservative assets, like Treasury bonds, and the other half in more aggressive assets, like stocks.
What Is a Risk Profile Example?
Risk profiles can be created in a number of ways, but traditionally, they begin with a risk profile questionnaire. Risk profile questionnaires and other strategies, which might focus on an investor's environment and life experiences, score an individual via various probing questions to come up with a risk profile, which is later used by financial advisors (both human and AI) to help shape a portfolio's asset allocation.
This asset allocation will directly affect the risk in the portfolio, so it's important that it aligns well with the individual's risk profile—that is, their willingness and ability to take on risk.
Willingness to take on risk refers to an individual's risk aversion. A risk-averse investor, for example, is someone who says that they essentially never want to see the value of the account decline, even if that means missing out on potential capital appreciation. If, on the other hand, an individual expresses a desire for the highest possible return—and is willing to endure large swings in the value of the account to achieve it—this person would have a high willingness to take on risk. They may even be a risk-seeker.
The Bottom Line
A risk profile outlines how much or how little risk an individual or organization is willing and/or able to carry. An appetite for risk is not the same as a capacity to weather it. An overly aggressive investor or company might be willing but not able to take on a certain level of risk, whereas one who is overly conservative might be able but not willing to. A risk profile is a way to tell that story.
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