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Tell apart an investor's return objectives and their tolerance for risk

CFA® Level I · Portfolio Construction · Basics of Portfolio Planning and Construction · PM.3.b

The idea

A return objective states what the portfolio must achieve, often expressed relative to a spending requirement, an inflation rate or a liability. Risk tolerance has two distinct components that are frequently confused: the ability to take risk, which is objective and follows from wealth, time horizon and the importance of the goal, and the willingness to take risk, which is psychological. Where the two conflict, the prudent course is to adopt the lower of them and to discuss the gap with the client, rather than to average them into a figure reflecting neither.

Formulas

Required return from a goal

required return = [(1 + real return) × (1 + inflation) − 1] ÷ (1 − tax rate)

real return
the growth in purchasing power the goal needs
inflation
the expected rise in prices
tax rate
the share of returns paid in tax

A simple illustration of the chain from need to required return: allow for inflation, then gross up for tax. The curriculum leaves detailed tax treatment to later levels.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does a return objective state?

  1. The maximum loss the portfolio may sustainWhy not: That belongs to risk tolerance, the other objective.
  2. What the portfolio must achieve - correct
  3. How the portfolio will be taxedWhy not: Tax is one of the five constraints and is not what the return objective expresses.

A return objective states the return the portfolio must or should earn to meet the client's needs, such as covering spending, keeping up with inflation or paying a future liability. Required return is roughly Spending rate + Inflation. Example: a client withdrawing 40,000 a year from an 800,000 portfolio spends 5.0%. To keep pace with 2.5% inflation, the portfolio needs about 5.0% + 2.5% = 7.5% a year, before taxes and fees. The loss a client can stand is the risk objective instead.

A harder one

Gareth Doyle, 68, retired last year. His $900,000 portfolio must fund withdrawals of $54,000 a year, and he has no pension or other assets. On the adviser's questionnaire he scored as a very aggressive investor and says he is comfortable with falls of 35% in value. The adviser judges that his ability to take risk is low. Which should the adviser use as the basis for his risk tolerance in the investment policy statement?

  1. Willingness, since it is the client's own choiceWhy not: Willingness is psychological and does not create capacity. A 35% fall would force Gareth to sell heavily to fund withdrawals, so a stated preference cannot override what the finances can bear.
  2. The average of the two, since both matterWhy not: An average gives a figure that reflects neither component and still commits him to more risk than his finances can support. The prudent rule is to adopt the lower of ability and willingness.
  3. Ability, since it is the lower of the two - correct

Risk tolerance has two parts. Ability is objective and comes from wealth, income and how much the money is needed. Willingness is how comfortable the client feels about risk. Gareth's withdrawals are 54,000 / 900,000 = 6.0% of the portfolio, and he has no other income. A 35% fall would force heavy selling to fund them, so his ability is low even though his willingness is high. Rule: use the lower of the two. The adviser should also discuss the gap with him. Averaging would reflect neither.

The hardest tier

An adviser records a high risk tolerance based on a questionnaire alone. What has been missed?

  1. The client's tax positionWhy not: Tax position is a constraint gathered separately; it is not the missing half of risk tolerance.
  2. The client's benchmarkWhy not: Chosen later, to match the resulting policy. It is not an input to risk tolerance.
  3. Ability to take risk - correct

Risk tolerance = the lower of willingness and ability. Willingness is psychological, and a questionnaire mostly captures it. Ability is objective, based on wealth, time horizon and income needs. A high score in calm markets says nothing about whether the client could survive a loss. Example: a retiree who scores as aggressive but lives off the portfolio has low ability. So the lower of the two should drive the policy statement. Tax and benchmark are separate matters.

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