Adapted by Lisa M. Laird, CFA, from “Communicating Clearly about Investment Objectives and Risks” by Karyn Williams, PhD, and Harvey D. Shapiro, originally published in the July/August 2021 issue of Investment and wealth monitor.1
Earlier in this series, we discussed the need for clear communications early in the investment process and noted the communication challenges that come with traditional investment decision frameworks and risk concepts. Here, we present a holistic approach that directly connects objectives and risks with new decision metrics, namely Portfolio Pi and Portfolio Eta, which were developed by Jakša Cvitanić, Scientific Advisor at Hightree Advisors, and Karyn Williams, PhD.
These metrics allow decision makers to make direct trade-offs between competing objectives. We show that using a shared language that is meaningful to investors can help ensure that the chosen investment strategy better serves its purpose.
| Pi wallet is a weighted average of the probabilities of achieve desired investment goalswhich includes avoiding specific losses, in an investment horizon. Applied in context, the Hightree Pi Score summarizes an investment portfolio’s potential to achieve goals and avoid losses. |
| Portfolio I is the economic value that an investor can gain or lose between portfolios with different Pi scores. Portfolio Eta fully summarizes, in terms of dollars or percentages, the differences between returns, risks and costs of portfolios. |
Risks that matter, achievable goals
Being specific about what we want our investments to deliver (target returns, for example) says nothing about whether what we want is achievable. Investment committees must explicitly acknowledge this. What does achievable mean? It means having a high probability of achieving return targets, given the amount of risk we can spend. And if the standard deviation is not a meaningful and useful measure of risk, as we saw in our previous article, we need a measure that is.
There are several ways to estimate risk capacity. One approach is to determine the available financial resources that the investment portfolio can lose without harming the entity’s purpose.
Next, the investor must assess the potential impact of pursuing target investment returns on their available financial resources. Let’s say a $100 million private foundation has a target return of 8.04% and has estimated its risk capacity at $25 million. That is, the most you can lose without impairing your ability to fulfill your purpose is 25% of your portfolio value. This risk appetite information makes it easier to evaluate an investment strategy by simply asking, “What is the average probability that the portfolio will meet our annual return target and not lose 25% over the next five years?”
The chart below shows the probabilities that the target return of 8.04% and the horizon loss limit of 25% will be achieved under each distribution assumption for three investment portfolios that the foundation is evaluating. These include the current portfolio, an equity portfolio and a higher equity portfolio. The lowest equity portfolio consists of 25% US equities, 25% non-US stocks, 40% fixed income and 10% broadly diversified hedge funds. The top equity portfolio consists of 35% US equities, 35% non-US equities, 20% fixed income and 10% broadly diversified hedge funds. For simplicity, all analyzes use indices and all figures and results assume a non-normal distribution of portfolio returns.
Probabilities of Success: Investment Objectives and Significant Risks
Under normal distribution assumptions, the odds of success are generally higher. If limit of loss is an important consideration, results based on a non-normal distribution of results provide critical information for decision makers about important risks.
Regardless of the distribution assumption, all of the portfolios shown above have low probabilities of achieving the target return. This is because the private foundation must spend 5% per year, real returns are expected to be negative, and asset premiums are insufficient to cover the gap. This is essential information: the foundation may not get what it wants, even if it increases its capital allocation to 100%.
These results are easily communicated and highlight the necessary trade-offs. How can the foundation choose between these three portfolios?
If the foundation weighs the relative importance of its target performance goal versus its loss limit, it can measure its potential for success as an average of the odds. This average, its Pi score, helps the foundation determine whether goals are achievable and which investment strategy is best.
The chart below shows the Pi scores for each portfolio, where weights have been applied to the target return and limit loss probabilities, representing the relative importance of each to decision makers. If the investor equally weighs the importance of achieving the target return and the loss limit, corresponding to the vertical line in the middle of the graph, the equity portfolio has the highest Pi score at 48%, slightly above current portfolio, which is 47%. This is determined by equally weighting the target return and loss limit objectives: Pi score of 48% = 50% weight × 32% chance of success in meeting the return target + 50% weight × 63 % chance of success in not breaching the loss limit.
Average probability of success, varied by the relative importance of target performance and loss limit, assuming a non-normal distribution of outcomes
Alternatively, the foundation could choose to weight its loss limit and target return differently. In fact, decision makers may want to evaluate a wide range of weights and outcomes. There is no correct answer. But with the metrics described here, the dialogue moves beyond vague generalities about “a lot,” “a little,” or “a little” to more precise statements of probabilities relative to the goals, especially the risks, that matter in the institution using a common criterion. the language and agreed preferences of those involved.
A complementary way to help judge whether one portfolio is preferable to another is to translate the differences in potential outcomes into dollar terms. The foundation board may ask, “How much money would we need to add to our current portfolio to achieve the highest Pi score of the highest equity portfolio?”
The chart below illustrates the differences in dollar value (and percentage return) (i.e. Portfolio Eta) between the current portfolio and the lowest and highest equity portfolios when the foundation board puts a weight of 80 % on the target performance and 20% weight on the loss limit.
Economic value differences between portfolios: 80% target return target, 20% risk limit weighting
The chart above shows that given the foundation’s target return objective, loss limit and weightings, the higher cap portfolio is “worth” about $2.2 million more than the current portfolio over investment horizon of five years. This equates to an additional 0.44% return per year, a return that is left on the table with the current portfolio. This is not a small sum for the foundation and a value that is difficult to achieve through manager alpha.
Still, the foundation’s board may not feel comfortable with a low probability of meeting its return target or confident enough about downside risks. Using these metrics to help balance what it wants against significant risks, the foundation could review its return target and consider changes to its portfolio construction, active and passive managers, risk management activities and other attributes of the cycle. of life of the investment.
Unfortunately, these metrics do not provide absolute, definitive, and unassailable answers. Rather, they contextualize investment concepts, especially the concept of investment risk, so that everyone involved speaks the same language and understands the potential impact of their choices.
conclusion
All fiduciaries, regardless of role or experience, can clearly communicate investment objectives and material risks. Direct measures of the probabilities that fundamental goals and limits can be met, weighted by agreed preferences and combined with comprehensive comparisons of portfolio strategies in dollar terms, provide a more accessible and disciplined decision framework for all stakeholders. Even newcomers to the world of investing can feel more confident that they understand their choices and are doing everything they can to protect and maintain the purpose of investment assets.
1. Investment and wealth monitor is published by Investments & Wealth Institute®. The full original article can be found here: “Communicating Clearly About Investment Goals and Risks.”
If you liked this post, don’t forget to subscribe to Entrepreneurial investor.
All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / skynesher
Professional training for CFA Institute members
CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Entrepreneurial investor. Members can easily register credits using their online PL tracker.
Lisa M. Laird, CFA
Karyn Williams, PhD
Harvey D. Shapiro
