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
Effective investment management requires clear communications. Everyone involved needs to understand the returns they are looking for and the risks they are taking. But the amorphous quality of some crucial investment concepts, particularly investment risk, often makes such communications difficult to achieve.
In this first installment of our three-part series, we discuss the need for clear communications early in the investment process and how goals are the foundation for core investment strategy decisions.
The setting
In any major institution, the investment process requires collaboration. The ideas and opinions of participants, from executives and board members to investment managers and outside consultants, should be heard and evaluated even if they are not necessarily implemented. Extensive and intense communication is essential.
In the investment world, however, communication is difficult. The language of investing is not always intuitive and can seem opaque, often obscuring as much as it reveals. Some concepts can be expressed simply and precisely to the third decimal place. Others are more difficult to define and understand. As a result, deliberations take place in what may seem like a foreign language to non-practitioners, and some participants may believe they understand and understand each other when they do not.
The success or failure of these dialogues shape important decisions at every stage of the investment process.
From purpose to investment objectives
For most major investment groups, the overall purpose may seem clear enough. The money is there to generate funds to support charitable activities, secure retirement income, pay future insurance claims, or produce income for family members now or in the future.
Once the purpose is established, there needs to be a granular discussion of the goals to determine how financial resources should be invested to support that purpose. For example, a philanthropic foundation should set specific program goals, because it cannot do everything for everyone.
Once the foundation commits, for example, to supporting the arts, it must establish how long it plans to exist. Should it hand over all its money as quickly as possible to meet the critical needs of the arts and then go out of business? Or should he commit to supporting his mission in perpetuity? Either option is reasonable, but if it’s the latter, the foundation must create a grant program backed by an investment program that ensures it lives within its means.
Decisions about which goals to pursue involve difficult and sometimes painful conversations, and the vocabulary of investing can sometimes obscure goals or obscure options. Also, these decisions are never one and done. Interim corrections are often necessary responses to changes in investment results or changing circumstances. For example, numerous foundations were created to support orphanages in the 19th and early 20th centuries. But of course, the number of orphans and the way they are cared for is completely different today than it was a century ago. These foundations have responded accordingly, modifying their purpose and investment objectives to adapt them to the times and the evolving requirements of their mission. Therefore, periodically reconfirming purpose and regularly setting investment goals are essential parts of the investment process.
A practical approach is to set investment goals over continuous or continuous “investment planning horizons.” These can be as short as one year or as long as 10 years and are usually updated annually. For example, the table below shows typical components of target return goals over a five-year investment planning horizon for a $50 million public foundation, a $100 million private foundation, and a pension plan of defined benefits of $1 billion.
Example of five-year return on investment objectives
| $50 million public foundation | $100 million private foundation | $1 billion defined benefit pension plan | |
| Anticipated Annual Funding Needs/Payments | 3.00% | 5.00% | 3.50% |
| Expected inflation | 2.50% | 2.54% | 2.75% |
| Investment management fees | 0.75% | 0.50% | 0.55% |
| Portfolio growth | 0.50% | 0.00% | 0.20% |
| Target investment return objective | 6.75% | 8.04% | 7.00% |
Each of these investment organizations has varying degrees of discretion and precision in setting their return targets. A private foundation must pay at least 5% annually to maintain its tax-exempt status, but a defined benefit pension fund requires only an estimated payment, and a public foundation can have substantial discretion in its spending. However, every organization has a profitability target for the five-year horizon, even if it expects to serve its purpose indefinitely.
Once investment return goals are estimated, investors should develop the investment strategy. Maximizing returns may seem like a reasonable goal, but that’s easier said than done. It can mean accepting substantial risk, which creates the potential for setbacks that limit an organization’s ability to meet its goals.
This balancing act is further complicated by the lack of symmetry in the language of investment. Risk and return are the yin and yang of investing. The return measures are concrete and allow for meaningful comparisons over time and a variety of portfolios. But the risk is nebulous and difficult to measure. Is it volatility? Tracking error? Any decrease in value? A cataclysmic descent? Doing something other people think is stupid?
That’s why identifying investment objectives and achieving stakeholder buy-in is the critical first step in connecting objectives to portfolio construction. And this requires overcoming the shortcomings inherent in how we talk about risk and other investment concepts.
The communication challenges that accompany traditional investment decision frameworks and risk concepts such as standard deviation will be the subject of the next installment in this series.
1. Investment and wealth monitor is published by Investments & Wealth Institute®.
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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.
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Lisa M. Laird, CFA
Harvey D. Shapiro
Karyn Williams, PhD
