IPS Components: Risk Objectives
You meet with your client Professor Jane Jackson, who makes $100K and saves $20K annually. She has $200K in savings and hopes to send her accomplished son to MIT in a couple of years. Like most other professors, she is very risk-averse and convinced the stock market is no different than a casino. How would you classify Jane's risk tolerance?
That's right!
Surely not.
Next, you meet with another client, Latoy Jackson, who makes $500K as a real estate agent and saves $200K annually. She has $800K in savings and hopes to have a comfortable retirement in 30+ years. She goes skydiving and does day-trading in her spare time. How would you classify Latoy's risk tolerance?
Actually, it's just the opposite.
Exactly!
Latoy has a high ability to bear risk given her income and savings. Her long time horizon also increases this ability. Skydiving and day-trading show her willingness to take risk is high. Combining these two, she has high risk tolerance.
Why is understanding risk tolerance so important?
No, you do not need to understand risk tolerance to understand risk. But, by understanding risk tolerance you are able to judge whether a given set of risk objectives are consistent with a client's risk tolerance.
Precisely! By understanding risk tolerance you are able to judge whether a given set of risk objectives are consistent with a client's risk tolerance.
There are three kinds of risk objectives. Typical examples of an absolute risk objective are not losing any money or not losing more than a given percent of capital in any given time horizon. Relative risk objectives relate risk relative to a benchmark. Which of the following do you think would make a plausible absolute benchmark?
Not quite. Risk objectives are about losing money and risk-free rate is a more plausible risk objective benchmark than market return since it's lower.
The third and last kind of risk objectives is a mix of absolute and relative risk objectives.
Right on! Not desiring a return less than the risk-free rate is a plausible risk objective.
The third and last kind of risk objectives is a mix of absolute and relative risk objectives.
In summary,
[[summary]]
The risk tolerance of a client should be made very clear in an investment policy statement (IPS). This will help the portfolio manager to pin down the risk objectives for the client. These objectives will then help build a portfolio with riskiness suitable for that client. In order to figure out the risk tolerance of a client, we gather information on the ability of the client to bear risk and also the willingness of the client to bear risk.
Between her low savings figures and short investment time horizon, Jane has low ability to bear risk. Her willingness to bear risk is low as well given her high risk-aversion and view on the stock market. Based on these two, her risk tolerance is low.
Low
High
Low
High
Because that's how you can assess the appropriateness of risk objectives for your clients.
Because without an understanding of risk tolerance you cannot truly understand risk objectives.
Market return
Risk-free rate
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