Investment Policy Statement: Risk

Posted By: Advisor Analyzer Team

Objectives: Ability to Take Risk

Much like return objectives, risk 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 risk is determined by the factors listed below.

Ability: Size of portfolio relative to objectives

A client's ability to take on investment risk depends on the size of the portfolio relative to their overall goals. If the investment objectives are feasible relative to the investor's overall portfolio value, the client has a greater likelihood of meeting their goals. Therefore, the client has a greater ability to stomach investment risk.

Ability: Significance of the investment objectives and goals

The ability to accept risk also depends on the significance of the investment objectives and goals. As discussed earlier, client's return objectives are further subcategorized into critical and secondary goals.

 

Critical goals related to financial security, maintaining their current lifestyle and providing for loved ones will dampen one's ability to take on more investment risk, when these objectives are not met.

 

Secondary goals, associated with acquiring luxury items, building second homes or taking lavish vacations are less pivotal to meeting primary objectives and may allow the investor to accept higher levels or risk.

Ability: Maximum acceptable level of portfolio fluctuation

As the probability of satisfying one's critical goals decreases, the allocation towards low risk investments in one's portfolio must increase. Successful investing does not mean swinging for the fences at all times, but more of a slow and steady RBI process. Investors who are far from reaching their critical goals cannot afford the luxury of taking a shot on a high risk high return situation. Stable and steady investments are generally more suitable for these investors as oppose to the ten bagger they heard about at their neighbor's barbeque.

Objectives: Willingness to Take Risk

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. Some factors that affect the investor's willingness to accept risk are listed below.

Willingness: Past portfolio depreciation and investment losses

When dealing with investors, the adage "Once burnt twice shy" reigns supreme. Investors are usually less willing to incur higher levels of acceptable risk if they have experienced a painful investment loss in the past. While advisors may be confident the client has the capacity to accept higher levels of risk, they must always respect the client's willingness. Advisors should make recommendations that are not only suitable for the client's ability, they must also ensure the investment coincides with the investor's willingness to those risk levels.

Willingness: Specific investment criteria

Many investors have unique investment goals outside of retirement. Typical client specific investment goals include wealth transfer, charitable donations, children's college education etc... Investors with financial obligations outside of their own usually are unwilling to participate in higher risk investments. There harbor a fiduciary responsibility outside of their own requirements and tend to overweight conservative investments in their portfolios.

Conclusion

Investors should utilize an IPS to facilitate their future financial objectives. Financial objectives revolved around both risk and return, and they are further categorized into both quantitative and qualitative factors. While defining these objectives are crucial in establishing a well thought out IPS, it is inadequate to fully extract the IPS's benefits. Investment constraints must be taken into consideration in the development process to fully cover the various aspects of an investor's financial profile.