Investment goals, risk and return in the IPS
Describing the investment, risk and return goals is one of the most important phases in the construction of the Investment Policy Statement or IPS.
Setting objectives makes investors less likely to react to market changes. If we are working towards a goal or objective, and not in search of random, occasional returns, or to beat the market or a benchmark, emotional and hasty decision-making is substantially reduced.
The Investment Policy Statement (IPS) should promote linking the assets to be invested to one or more investment objectives. It is a way of describing the overall objective of the investment.
Among the most common objectives and goals, we highlight:
- Long-term maintenance of lifestyle;
- A supplement to income, whether current or in retirement;
- Buying a new home or other durable good;
- Finance health and welfare and education costs;
- Leave an inheritance or legacy;
- Achieve financial independence;
- Invest in your own business.
The return on investment objective must be carefully defined and may incorporate a description of financial needs and their relationship to factors such as inflation or consumption, growth or maintenance of wealth.
In order to calculate the return objective, it is also important to define assumptions or policies for distribution and expenses. This reconciliation between return on investment, rates, taxes, inflation, and projected expenditure targets is useful as a guide to a more realistic estimate. Distributions and expenses can be characterized as a percentage of the market value of the portfolio or as a specific cash value.
Required return and Desired return
In defining the objective return, it is very important to distinguish between a Required return and a Desired return. The first refers to the level of return needed to achieve key long-term critical financial goals and objectives. The latter is associated with the investor's secondary goals and objectives.
Required returns are typically driven by the level of annual spending and long-term savings goals. Historically, these goals have been classified as income and growth. The income (dividends, interest, rents) from the portfolio is used for current income and the portfolio earnings are reinvested for growth.
However, these terms, although widely used today, blur the distinction between the return required by an investor and his tolerance for risk. Income-oriented portfolios are typically biased towards a lower level of risk and highly concentrated in bonds (fixed income). On the other hand, a growth portfolio is equity-oriented, with a low direct relationship to risk tolerance.
Also important to mention inflation. Normally the required returns are presented in real terms, without adjustment for inflation. However, when current expenditures and long-term financial objectives are presented in terms of purchasing power, it becomes clear that even the most income-oriented portfolios require a considerable level of nominal growth.
Thus, a total return approach to define the investor's required return should be the most appropriate one to define in the IPS. The investor's financial goals are first met, and then the annual after-tax return needed to achieve those goals is identified. This return must then be reconciled with risk tolerance, determined separately, and with constraints, restrictions and preferences.
With the notable exception of tax considerations, it is typically less important whether the total return on investment comes from yield or price appreciation.
The definition of this set of goals, in terms of investment, return and risk, should work as a relief from the weight that the financial reality carries in our day-to-day. We must avoid financial pressure and work with the IPS to instill a more rational relationship with money and with saving and investing.
An individual's objective risk, or risk tolerance, is defined in terms of the ability and willingness to take risk.
The ability to take risk is determined by financial goals taking into account available resources and the time to achieve those goals. If the financial objectives are relatively modest relative to the investment portfolio, clearly the investor has a high capacity to take risk, to accommodate volatility and negative returns in the short term. If the investment portfolio grows and the time horizon increases, the ability to recover from intermediate declines also increases. Everything else constant, long-term goals allow the investor to consider more volatile investments, with the corresponding gain in the expected return.
Critical objectives allow for a smaller margin of error and reduce the ability to accommodate volatility. Financial security and the ability to maintain the current lifestyle are among the investor's highest priorities. The limit on the ability to accept risk is reached when the probability of failing a priority objective becomes unacceptably high.
In contrast to the ability to take risk, investor willingness involves a more subjective assessment. Tracing the investor's psychological profile is essential to estimate the willingness to take risk. If the investor has already experienced situations of large losses and large gains, it is easier to generate a debate regarding risk tolerance.
All these considerations must be defined in the IPS, recognizing that the portfolio will be subject to risk taking and that the return associated with the risk can be positive and negative over time.
The material risks are diverse and may include liquidity, legal, political, regulatory, longevity, mortality, business and health risks. In addition to specifying relevant risks, defining acceptable risk paths can also be important. For example, taking into account possible personal risks (ie job loss, illness, life cycle stage), an absolute level of loss that would jeopardize the sustainability of the investment portfolio makes "volatility" a descriptive measure of irrelevant risk.
For this reason, in addition to volatility, we must also consider measures such as the maximum portfolio decline in a given period or as a percentage of the portfolio.
Wherever possible, the IPS should contain an assessment of investors' intellectual and emotional tolerance for potential losses associated with risk. For these assessments, interviews or questionnaires can be used. The results of this type of analysis may suggest limits and policies associated with the level, for example, of portfolio rebalancing, rebalancing and maximum loss.
Vítor is a CFA® charterholder, entrepreneur, music lover and with a dream of building a true investment and financial planning ecosystem at the service of families and organizations.