Wealthsimple's assessment of risk starts with the investor because the whole point of investing is to help yourself improve your life prospects and outcomes. There are four dimensions of risk we consider:
- Portfolio risk
- Risk required
- Risk capacity
- Risk tolerance
Keep reading below to learn more about each of these in more detail.
Portfolio risk is the expected range of outcomes of a given portfolio. There are a few observations about portfolio risk that we consider:
- Riskier assets have a larger range of outcomes,
- Diversification narrows the range of portfolio outcomes
- For diversified portfolios, expected returns increase as portfolio risk increases
- The median of the expected range of outcomes improves over time
To turn these principles into usable advice, we use some statistical techniques to model the range of expected outcomes for portfolios, which then helps us determine the appropriate portfolio for an investor given their individual situation. You can see this range represented in the app as a cone chart, which gives our best estimate of the range of outcomes in each portfolio.
Risk required is the amount of risk an investor needs to take in order to achieve their goals. If an investor has a long-term goal to maximize wealth, they tend to require more portfolio risk because expected returns are higher, and the lower end of the expected outcome is acceptable.
If an investor has a goal of ensuring that they can make a specific payment in the short term and they are on track to have saved most of the money required, they would tend to require a less risky portfolio.
For investors approaching retirement, many still need to take risk in order to meet spending goals because they will hopefully have a long time to spend the money they have saved.
Risk capacity is the ability of the investor to take risk when considering factors outside of the investment goal specified. An example of an investor with lower risk capacity is an investor who may use a meaningful portion of their savings to support occasional emergency needs of relatives. We wouldn’t want an investor to need money for their life and be unable to spend it due to market volatility, so would tend to reduce risk in those circumstances, or advise the investor not to invest at all. Investors with high risk capacity tend to have enough savings built up relative to future expenses, or significant current and future earnings capacity so they can continue to invest through market losses.
Risk tolerance is the willingness of the investor to withstand negative portfolio outcomes without making a panic-based investment decision. Our data suggests that most investors are able to withstand portfolio volatility and stay invested, but some make damaging decisions, for example exiting the market after a loss. These kinds of decisions can hurt long-term outcomes, so we try to help investors assess their ability to withstand these outcomes. We offer a lot of support for investors through the emotional process of withstanding volatility, but we also offer lower risk portfolios to investors who don’t believe they can withstand market volatility. The best portfolio is one that you can stay invested in. More experienced investors may consider how they have handled losses as a guide and what they have learned through investing to understand their future behaviour.