In today's article, we will clarify the concept of an investor profile, the difference between risk capacity and risk aversion, and the different investor profiles that exist.
What is the investor profile?
The investor profile is closely related to the level of risks vs. returns that an individual expects to obtain when making an investment decision (CNMV, 2012). In other words, it is the risk tolerance that an investor is willing to assume in order to obtain a certain expected level of return. To define an investor's risk profile, traditional finance uses the concepts of classical decision-making, modern portfolio theory and the capital asset valuation model (CAPM) (Klement, 2016). In this model, investors are inherently risk-averse and only assume additional risk if they believe that the increase in expected returns will compensate them. According to a study by the CFA Institute Research Foundation that analyzes the investor's risk profile, in reality, investors face restrictions and do not act according to the rationality model used in traditional finance (Kahnemann 2012). The same study proposes to distinguish between risk capacity and risk aversion to address problems between theory and practice. Risk capacity applies to an investor's objective capacity to assume financial risk (Klement, 2012). This capacity depends on objective economic circumstances, such as:
- The investment time horizon
- Liquidity needs
- The investor's income
- The assets available for investment
Risk capacity does not include any subjective perception. That's the big difference with risk aversion, which is the combination of psychological traits and emotional responses to determine an investor's willingness to take financial risk (Klement, 2012). According to the CFA study, emotional factors are often more important to investors than objective economic factors. However, they are more difficult to measure.
What types of investor profiles are there?
The combination of risk capacity and risk aversion establish the investor's risk profile. In Spain, according to the National Securities Market Commission (CNMV), there are 3 investor profiles: conservative, moderate and aggressive.
Conservative Investor Profile
In this profile, investors are less tolerant to risk, that is, they value more the security that can come with keeping the “principal” of their capital almost intact. You need investment instruments that give you reliability and that don't involve much risk. It prefers to preserve its capital and values the level of profits or performance less. Therefore, it will invest more in debt instruments or fixed-term deposits. It should be noted that, at times of high inflation such as the present, these investments should be classified as being of higher risk because inflation strongly liquefies preserved capital. Therefore, the most advisable thing in these circumstances is to invest in bonds, but especially those linked to inflation.
Moderate investor profile
The moderate profile is characterized by being cautious with their decisions. It tolerates risk more than the conservative profile, especially to increase its profits. Always try to keep a balance between safety and performance. He usually invests a part of his savings in deposits or fixed income and another small part in equities to achieve more returns. Investments in equities are usually made in investment funds or ETFs linked to companies that regularly pay good dividends, such as energy or mass consumption companies.
Aggressive investor profile
This profile values profitability more than safety. He has little risk aversion and is willing to invest in riskier assets in exchange for higher profits. You can make investments with more uncertainty. They tend to invest in equity funds or ETFs linked to the S&P or Nasdaq, technology startups, and so-called “junk bonds” or “high yield”.
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