Understanding your risk profile is the first step in choosing a suitable asset allocation. Your risk profile determines your asset mix. It depicts the extent of losses you’re willing to make in exchange for potential gains, and it depends on your age, investment goals, and financial security.
Generally, the higher the risk, the higher the returns. Risk takers are commonly attracted to investments with greater uncertainties, such as stocks, which promise potentially higher returns but could also be more volatile.
On the other hand, risk-averse investors prefer a more conservative asset allocation that will produce a steady income but lower returns.
Your investment horizon is another factor in your risk profile. If you’re looking to see results in a shorter period, a conservative mix might not bode well as instruments such as bonds yield lower steady returns over a relatively long period of time. For example, investing in bonds for a 25-year-old would be rewarding as he has a longer time horizon to wait, compared to a future homeowner trying to make enough to pay for a housing down payment.
This is why we recommend an age-based approach to investing, as life goals and time horizon correlate with age.