Subject 2. Investment Risk and Return Objectives, and Risk Tolerance

The investor's objectives are his or her investment goals expressed in terms of both risk and return. Why?

  • The investment decision is a trade-off between risk and return, and that trade-off varies depending on the preferences and situation of each investor.

  • Investment objectives expressed solely in terms of returns can lead to inappropriate investment practices, such as the use of high-risk investment strategies or account "churning," which involves moving quickly in and out of investments in an attempt to buy low and sell high. If achieving high investment returns is the only goal, the portfolio manager may, for example, invest funds in high-risk assets, which have a high possibility of loss. For a risk-averse investor (e.g., a retiree), such an investment strategy makes little sense.

  • A careful analysis of the client's risk tolerance should precede any discussion of return objectives; it makes little sense for a person who is risk-averse to invest funds in high-risk assets.

Investment firms survey clients to gauge their risk tolerance. Risk tolerance is an investor's attitude toward risk. It is segmented into ability and willingness to assume risk.

  • The ability to assume risk is based on financial and circumstantial restrictions. Most often, a client's ability to take risks is determined by factors such as time horizon, current insurance coverage, cash reserves, family situation (i.e., number of children), age, current net worth, income expectations, etc.

  • While the ability to accept risk is usually measured on a quantitative basis, an investor's willingness to assume risk is based on more psychological factors. It takes into account the investor's overall perception of investment fluctuation and losses.

The investment adviser should work with the investor and reach a conclusion about the investor's risk tolerance consistent with the lower of the two factors (ability and willingness).

Risk objectives are specifications for portfolio risk that reflect the risk tolerance of the client. Quantitative risk objectives can be stated on an absolute or a relative basis. For example:

  • Absolute risk objectives: not to lose more than 5% of the capital within a 12-month period; portfolio standard deviation not to exceed 25% at any time, etc.
  • Relative risk objectives: match the performance of S&P 500, achieve returns within 3% of the DJIA, etc.

Return objectives can be stated in terms of absolute or a relative percentage return, or other terms. For example:

  • 20% capital growth.
  • beat the S&P 500 by 2%.

The return measure can be stated:

  • before or after fees.
  • on either a pre- or post-tax basis.
  • as nominal or real returns.

User Contributed Comments 3

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jonan203: personally, i'd rather have consistent absolute returns rather than relative returns.

market goes down 30% and your only down 20%, best of the worst, no thanks.
RamaG: nice dream
farhan92: jonan - this may answer a question, I saw in an earlier chapter, about why bonds are preferable to stocks.