Forming an Investment Risk Objective
Since risk and return are related, risk objectives largely influence the return investors can expect to earn.
The first part of a risk objective is to determine how risk should be measured. Often this is done in terms of volatility - the variance or standard deviation of various assets or the overall portfolio. However, it can also be expressed in terms of tracking error relative to a benchmark or in terms of the risk of loss (downside risk or Value at Risk).
The investors willingness to accept risk must be considered, along with the ability to accept risk. Ability to accept risk is influenced by how much volatility would inconvenience the investor or make it difficult to achieve desired wealth targets. Liabilities and the investor’s financial strength outside the portfolio (income) also constrain risk taking. The willingness and ability to accept risk together form the investor’s risk tolerance or aversion.
Risk tolerance must be specified. Saying the investor has low risk tolerance is not as useful as outlining a plan that “loss in any year should not exceed 10%.”
Once the risk tolerance is established, the risk should be budgeted among the various asset choices available in order to maximize the potential return within the investor’s risk tolerance.
For more information, see all articles on: Active Management, Asset Allocation, FInancial Planning, Portfolio Management See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
[...] return objectives should be consistent with established risk objectives. How the return objective will be measured (typically total return) is important. Will it be on a [...]
March 31st, 2008 at 7:52 am