Investment strategy: personal risk profile as a basis

It's going to be a bit dry today, sorry. But money matters are sometimes like that. The basis for defining a strategic asset structure or investment strategy is the so-called risk profile. The target range for defining the personal investment strategy is derived from the personal risk profile. As illustrated above, the risk profile includes various ingredients, namely the personal risk capacity, the personal risk appetite and the personal target return.

Risk capacity refers to the objective ability of a (private or institutional) investor to absorb losses. The analysis of risk capacity belongs to the realm of economics. For the concrete assessment, the probability is determined as to whether the investor can cover future expenses with his assets and future income. If this probability is not high enough, there is a risk – in accounting terms – that the investor becomes insolvent or, to put it simply, goes bankrupt.

Risk appetite measures the investor's subjective willingness and preference to deal with investment risks and possible losses. The analysis of personal risk appetite belongs to the realm of psychology and many imaginative concepts have been developed in the industry to measure personal risk appetite. We are not psychologists and therefore refrain from commenting further on this topic.

Ultimately, the target return measures the minimum return that an investor wants to achieve or – in the case of an institutional investor such as a pension fund – must achieve in order to finance the promised benefits. For private investors, the concept of target return is somewhat diffuse and cannot be defined very precisely; therefore one often speaks of investment objectives that should be achieved.

If you conclude an asset management mandate or a pension securities solution (pillar 3a or vested benefits) in Switzerland, the provider is obliged under the suitability test defined in Art. 12 FinSA to conduct a personal risk profiling before the contract is concluded. We criticize two aspects of the established market practices in this regard. First, risk profiling is usually carried out only with regard to the amount invested and not with regard to the investor’s overall financial situation. As explained in Economico Flash 14, investors do not have separate risk capacities for different parts of their wealth but only one overall risk capacity derived from their total financial situation.

Second, many risk-profiling approaches used in the industry focus on risk appetite and therefore the psychological aspect rather than on risk capacity and thus the economic aspect. In our view, it would actually be the industry’s responsibility to deal more intensively with the economic dimension.

As a result, the question arises whether the pre-contractual risk profiling really provides concrete value for you as a client, or whether you would prefer to define your investment strategy yourself. On Economico we have provided a simple risk-profiling tool that may help you with this task.