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What does it mean by 401k risk profile?

I want to know about the 401k risk profile? how to understand it. Please give a complete definition.

May 08, 2012 by Smith from Auburn, MI in  |  Flag
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It is difficult to answer your question without seeing the report to which you refer. "401k risk profile" could refer to the risk of the underlying investments in a plan account. In general, a higher allocation to equities (through equity mutual funds) leads to a higher portfolio risk profile. Portfolio risk is often measured in terms of annualized standard deviation or volatility, which is used to provide a standard estimate of expected losses. Return is generally directly correlated with risk, so a higher risk profile usually implies a higher expected portfolio return.

If the 401k risk profile is related to your specific circumstances, then it may also consider non-investment risk factors such as your age, account balance, and spending needs in retirement. Someone who has many years until retirement has a higher risk capacity than someone who is close to retirement, and this type of age-based analysis is usually factored into an individual's risk profile (greater risk capacity allows for a higher risk profile).

I hope this helps. Feel free to post again if you can provide more detail.

2 Comments   |  Flag   |  May 08, 2012 from San Francisco, CA
Brice Thompson, AWMA, AAMS

Smith, please let me add to these two excellent answers with a bit of a different perspective. The Risk Profile Questionaire is based on Modern Portfolio Theory which many do not subscribe to. In simplest terms, it is an attempt to quantify and reduce risk/raise returns by mixing together non-correlating assets(Asset Allocation) with a grading system that can be applied to large numbers of people uniformly without a lot of cost. The problem is that it doesn't always work and it doesn't address the individual's "need" as opposed to their "want". What I mean by that is that if you have 10 years until you must retire and you NEED to accumulate $1,000,000 to generate $40,000/yr for retirement income and you currently have saved $300,000 then your NEED will be dramatically different than your recommended asset allocation based on your Risk Profile. The problem there is that you may be 60 years old, hate losing money, and only want "safe" investments and the recommended asset allocation will give you NO CHANCE of reaching your goal.

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Flag |  May 09, 2012 near Columbus, GA
Brice Thompson, AWMA, AAMS

I apologize, I didn't mean to submit the answer just yet. RISK PROFILE questionaires are attempt to help investors know where they should put their money, but it is only a small part of the equation. In my hypothetical scenario above, I would helped an investor determine if they do in fact actually NEED $1,000,000 in 10 years to produce the necessary supplemental retirement income, or not. If not, then they would not need to take so much risk and they could take advantage of lower volatility investments as the lower returns will still help them be successful. Conversely, if a person needs a substantial gain over time, then they will need to invest more in the "risky" investments whether they "want" to or not.

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Flag |  May 09, 2012 near Columbus, GA

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George Cones, JD Level 20

I just want to add a bit to James's answer. Many times, plan participants answer a questionare. One of the areas addressed is the psychological aspect of risk. Your Investment Advisor may have you answer a questionnaire to help establish your risk profile. You will be asked question about your age, how long you have until retirement, your assets, your life insurance, etc. You are often asked questions like, “If your portfolio dropped 20%, would you consider changing your allocation?” These questions are attempting to get at how you can handle downside movements (usually paper losses) in your portfolio.

Did you know that since 1926, on an annualized basis: US large cap stocks returned 9.8%, US small stocks returned 11.9%, World Stock Markets X US returned 7.9%, Long-Term Government Bonds returned, 5.7%, and 30 Day Treasury Bills (cash) returned 3.6%.

Where would you place your money to get the most return? US small capitalization stocks, right? Remember there are two sides to risk, upside and downside. If we use the historical expected return of small cap stocks, 11.9%, using the rule of 72 (return into 72) our portfolio should double in 6 years, and again in another six years, and so forth. If we put all or part of our investment in large cap US stocks (like the S&P 500 or the Russell 1000), using the historical expected return of 9.8%, and the rule of 72 this portion of our portfolio should double in 7.35 years (72/9.8%). Following this same logic, If we invested all or a portion of our portfolio in 30 day t-bills with a return of 3.6% it would take 20 years to double the investment. But since we live in the real world, we have to understand that while we may expect long-term returns to approximate historical returns, there may be a lot of downside risk in the short run. For the 5 years ending in December 2011, small stocks returned -0.5%, large cap stocks returned -0.2%, World X US stock markets returned -3.6%. If you were looking at your statement 5 years after you made a commitment to stocks and saw these negative returns, what would you do? Unfortunately, many investors would do the absolute worst thing, change their allocations. If you look the 10 year and 20 year numbers for these same areas of the market you will see they all did much better over the longer-term. For a person who has 20 to 30 years to retire, a diversified portfolio of stocks weighted 60-70% stocks, a diversified portfolio of bonds, and some cash should provide a competitive return, while dampening downside risk somewhat. Don't panic, understand the ride could be bumpy.

Of course as you move closer to retirement, your should consider adjusting your allocation.

Comment   |  Flag   |  May 09, 2012 from Wilmington, DE

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A risk profile (401-k or other) is a questionnaire that attempts to measure how much ups and downs an individual is comfortable with in their investments. In other words, how hard someone can bang your hand with a hammer, before you say " uncle" . I have not seen many that do that effectively or accurately. As a professional advisor, I usually get decent sense for an investors " risk tolerance" simply by spending time with- and getting to know them. And then observing how they react / behave after they are invested. If anyone has come across a questionnaire they feel can measure risk profile effectively, please be kind enough to share it with me at evan@completeadvisors.com Thanks!

Comment   |  Flag   |  Jun 01, 2012 from Port Washington, NY

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