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

CFA® Level I · Portfolio Management · 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.

A practice question

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

Which factor determines an investor's ability to take risk?

  1. Their wealth, time horizon and the importance of the goal — correct
  2. Their stated comfort with market declinesWhy not: That is willingness, which is about disposition rather than capacity.
  3. Their past investment returnsWhy not: What a portfolio has returned says nothing about what its owner could withstand losing.

Ability is a matter of circumstances and can be assessed objectively. Willingness is a separate, psychological matter.

A harder one

A client has a long horizon and substantial wealth but is deeply uncomfortable with volatility. How should the adviser resolve this?

  1. Adopt the higher of ability and willingness, since the objective measure is more reliableWhy not: Reliability is not the issue. A portfolio the client will abandon in a drawdown fails whatever the arithmetic said.
  2. Average the two assessmentsWhy not: A midpoint is still more risk than the client has said they can live with, and it has no principled basis.
  3. Adopt the lower of the two and discuss the discrepancy with the client — correct

A portfolio the client abandons in a downturn fails regardless of what the numbers permitted. Education may raise willingness over time, but the plan must be one they can hold.

The hardest tier

Why is a return objective stated as a percentage sometimes less useful than one stated relative to a requirement?

  1. Because percentage returns cannot be measured accuratelyWhy not: They are measured precisely. The question is whether the number chosen means anything for the investor.
  2. Because a bare percentage may be arbitrary — correct
  3. Because regulators prohibit percentage objectivesWhy not: No prohibition exists; percentage targets are common and unobjectionable where they are grounded in a need.

A required spending rate plus inflation defines what the portfolio must actually do. Anchoring the objective to the purpose makes it testable and makes the necessary risk explicit, while a number chosen without reference to need invites taking either too much risk or too little.

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