Risk and return objectives: willingness vs ability to take risk

What is a return objective?

A return objective states what the portfolio should earn. It is half of the client’s objectives, and it must be realistic: consistent with the risk objective and with the market environment. A 12% nominal target might be reasonable when inflation runs at 8% and unrealistic when it runs at 2%. If a client’s expectations are unrealistic, the adviser counsels them on what is achievable.

Return objectivemust be realistic and consistent with the risk objective

• Required return Memorize what the client needs to meet a goal
• Desired return Know the idea what the client would like
• Absolute or relative Use it a number, or a margin over a benchmark
  • Absolute for example, 6.6% a year
  • Relative for example, benchmark plus one percentage point
• State the basis Use it nominal or real; before or after fees and tax

• The required return is what the client must earn to meet a goal, such as a retirement income. The desired return is what the client would like. The investment policy statement (IPS) is built around the required return.
• A return objective can be absolute (a number) or relative (a margin over an index or a cash rate). Peer-group targets such as “top half of similar funds” are weak, because not everyone can be above average and a good benchmark must be investable.
• State the basis: nominal or real, before or after fees, and before or after tax. For a taxable investor the baseline is after tax.

How do you compute a required return?

Use it

If a client wants to keep the portfolio’s real value while spending a fixed amount, the portfolio must earn the spending rate and also keep up with inflation. The two effects multiply, so compound them.

$$R_{req} = \left(1 + \frac{S}{V}\right)(1 + \pi) - 1$$

Here $S$ is annual spending, $V$ the portfolio value and $\pi$ expected inflation. The additive shortcut $S/V + \pi$ is slightly too low, because it ignores inflation acting on the spending as well.

A different version of the same question gives a goal rather than a spending need. The goal is usually stated in today’s money, so the real growth needed is $(G/V)^{1/N}$, and inflation is added on top by compounding.

$$R_{req} = \left(\frac{G}{V}\right)^{1/N}(1 + \pi) - 1$$

Go deeper Why the return objective must not outrun the risk objective

Higher expected returns come with higher risk. If a client demands a high required return but accepts only low risk, the two objectives cannot both be met. The adviser’s job is to show the trade-off and ask the client to change something: a lower target, a higher risk, a larger contribution or a later retirement. Setting the return objective higher than the risk objective allows is a common planning error.

What is a risk objective?

Memorize

Risk objectives turn the client’s risk tolerance into limits on the portfolio. They come in three forms.

Risk objectivereflects the client’s risk tolerance

• Absolute Memorize self-standing, unrelated to market performance
  • Maximum loss no loss above 8% in any calendar year
  • Volatility standard deviation below 12%
  • Value at risk a probability statement about losses
• Relative Memorize risk measured against a benchmark
  • Tracking error standard deviation of return differences
  • Limit versus the index not more than 4% below it in any year
• Liability-relative Know the idea built around known future obligations (LDI)

An absolute risk objective stands on its own: “no loss greater than 8% in any calendar year”, “volatility below 12%”. Measures are standard deviation and value at risk (VaR). Because risky assets cannot promise “no loss”, such wishes are restated as probabilities: “with 95% probability, a loss of no more than 6% over any 12 months”.

A relative risk objective is measured against a benchmark: “do not trail the index by more than 4% in any year”, or a limit on tracking error , the standard deviation of the difference between portfolio and benchmark returns. It is a one-standard-deviation figure. A tracking error of 1.5% means that, if differences are roughly normal, returns stay within about 3 percentage points (two standard deviations) of the benchmark roughly 95% of the time.

A client who has known future obligations may want the portfolio built around them. That is liability-driven investment : the risk objective is to minimize the chance of failing to meet the payments, and a pension plan might aim to beat the discount rate of its liabilities. Insurers, defined benefit plans and retirees on a budget are typical cases.

Ability or willingness: which sets the risk?

Memorize

A client’s risk tolerance has two parts, and the exam wants you to keep them apart.

Risk toleranceability and willingness together; resolve any conflict

• Ability to bear risk Memorize objective facts
  • Time horizon longer means more ability
  • Income stable and secure means more ability
  • Wealth versus needs a large cushion over spending or liabilities
• Willingness to take risk Memorize attitude, a subjective factor
  • Psychology personality and comfort with losses
  • Experience and knowledge what the client has lived through
  • Assessment discussion or a questionnaire

	Ability to bear risk	Willingness to take risk
Based on	objective facts: horizon, income stability, wealth relative to needs, liabilities	attitude: personality, experience, questionnaire answers
Raises it	long horizon, large wealth against spending, secure income, pension surplus	comfort with losses, investing experience
Lowers it	short horizon, large near-term needs, unstable income, underfunding	anxiety about losses, a past bad experience

The ability to bear risk is judged mainly on objective factors. A 20-year investor can recover from losses; a 2-year investor cannot. The willingness to take risk , also called the risk attitude , is more subjective and is gauged by talking to the client or with a questionnaire. There is no single agreed method, and it can reflect knowledge and decision style as well as psychology.

Decision rule. When both are high, the tolerance is above average. When both are low, it is below average. When they disagree:

• Ability low, willingness high: go with ability. The overall tolerance is below average, and the adviser explains why.
• Ability high, willingness low: the adviser may counsel the client, explaining the conflict and the likely cost (lower expected return) of avoiding risk. The adviser should not try to change a willingness that does not rest on a miscalculation or misperception, because changing personality is not the adviser’s job. The prudent conclusion is the lower of the two, and the decision is documented.

Place each client card in the grid, then use the calculator under it to see how spending and inflation drive the required return.

Exam tip Compare, then pick the lower. Ability low and willingness high is the classic trap: the client “loves risk”, but cannot afford it.

Go deeper Why a questionnaire is only one input

A short questionnaire scores attitude to loss, comfort with the stock market and the importance of safety against returns. It is a useful prompt for conversation, but answers shift with recent market moves, wording and mood. Behavioral biases explain why willingness can be unreliable, which is a reason to cross-check it against the client’s actual behavior in past falls.

Go deeper Institutions: ability, stakeholders and conflict

A pension plan with a large surplus of assets over liabilities, or a strong sponsor, has high ability. Different stakeholders may want different risk: trustees of a well-funded plan may prefer low risk to protect the funding, while the sponsor wants higher expected returns to cut its future contributions. A trustee with a fiduciary duty to the beneficiaries acts in the beneficiaries’ best interests.