The investment industry tends to approach an investor’s investment objectives quite subjectively, and it is customary to merely ask the investor what they seek to achieve and use that as basis for recommendations.
It is important from a business prospective to look to ensure that the expectations of clients are at least somewhat in line with what may be expected from the investments that are offered. If not, clients are much more apt to be disappointed or even upset even when an investment strategy ends up working very well.
This is more a tool to look to align the objectives of clients more in line with the objectives of the various investment vehicles that are offered out there, although this does serve a practical purpose as well.
Assessing one’s risk appetite and tolerance is a separate process and risk tolerance is the far more important question of the two, because this will do more to determine what selection of investment products will be deemed suitable for the client.
Within a given risk tolerance, questions designed to determine one’s objectives won’t really end up excluding investment strategies and products like risk tolerance will, and assessing the profiles of clients are more about exclusion than inclusion.
Given that risk is really the most important of the two, in that we need to be seeking to avoid too much harm first, and then and only then look to achieve reasonable objectives, this is the proper way to approach this dynamic between risk and return with investors who seek our guidance.
Choosing Between Competing Objectives
What investors need to do is to look at both together though, taking into account the dynamic between risk and return and coming up with a strategy that takes care of both sides suitably. If a client, for instance, seeks high returns but is risk intolerant, they must be made to understand that there is a trade-off here, and one must choose the weighting that one wishes to give to each.
If higher returns are truly the primary goal, then one generally must be prepared to take on more risk to seek to achieve these returns, and the higher the goals, the higher the risk tolerance needs to be.
So, we can never just speak of investment objectives in isolation, although we do need to examine one’s expectations so that a certain goal can be arrived at, and then a certain weighting applied to it in order to assess what risk would be involved in striving to achieve the goal.
This does not mean that there is an absolute relationship between returns and risk overall, where striving for a better return always means taking on more risk, although the mutual funds industry would see it this way, but that’s only because they offer limited strategies and certain ones simply would not fit within them.
A different strategy may offer both better returns and lower risk, so if an investment returns a certain amount on average, seeking a higher return than this does not necessarily mean one must take on more risk, so this is all relative to differing strategies.
If for instance an investor expressed a desire to average a 50% return a year or better, one would be told that this goal is not achievable, especially over the long term, as the investments they offer and the strategies that these investments offer cannot even approach returns like this.
If our investor also expressed the desire to achieve these results while reducing their risk below market level, this would be seen as all the more unachievable. It is not that it is not achievable, but it surely isn’t with the investment products they would be offering.
Certain strategies can look to both manage risk and return to outperform both relative to the market and average performance of funds, and such results are not just limited to market savants either. One can employ strategies that both increase returns and reduce risk, and this is what hedge funds shoot for actually, and the good ones achieve this consistently.
If one wishes to increase returns, this does not necessarily mean that one needs to increase risk, even though the two objectives are in opposition, all things being equal. All things are often not equal though, and much of this is determined by investment strategies, each having their own particular relationship between risk and return.
Ultimately, the simple cookie cutter approach that investment advisors use, looking to simply decide which fund they sell best fits a client may work well within this sphere of investing, but it’s important to realize that the investment vehicles they sell do not comprise the entire scope of the possibilities out there, and even when an investor’s profile may fit one of their funds or combination of them perfectly, this does not mean that the client’s objectives are accounted for.
What we often end up seeking instead is the objectives of clients being limited to what the products offered may reasonably deliver, and when one’s objectives lie outside this, we are just told that we need to be realistic and reduce our expectations to conform with what they can deliver.
This does serve a practical purpose of course, as if one is looking to select from among certain investment options, then it becomes necessary to conform one’s choices to what is offered, but this is not the same thing as assuming that one’s objectives are unattainable simply because their advisors cannot help them achieve them.
Investment Objectives Aren’t Really That Subjective
While investors have certain needs, for instance to have enough money to comfortably retire on, making these objectives primary, even the sole determinant, is a lot like saying that people should set limits on their salaries based upon reasonable needs.
If you are applying for a job and express a desire for a certain salary that may be higher than what is offered, or even much higher, and you are told that the salary offered is enough to live comfortably on, you probably aren’t going to consider that to be all that persuasive.
If you are told that a certain investment strategy may average 5 or 10 percent a year and this should be enough for you, and if it isn’t, well too bad, that’s the best they can do, this shouldn’t be all that persuasive either.
If our prospective employer told you that there weren’t any other jobs out there, this will end up being very persuasive, although this is rarely the case. Perhaps you have set your sights too high, and there may not be better options out there, but this is something that needs to be explored, and you probably won’t just take the prospective employer’s word for it.
This is exactly what happens a lot with investment salespeople though, they will tell you things like there isn’t a way to do better than what they have, no one can really beat the market, you certainly don’t want to go this alone because it’s far better to have professionals manage your money, what do you know, and so on.
This is not to say that there aren’t people who are well served by these recommendations, even though the field has been narrowed to things like mutual funds, as for a lot of investors the field may indeed be that narrow. However, it’s important to know that one is not necessarily limited by these types of investments, and that it is at least possible to improve on these strategies.
Perhaps our true investment objectives do need to be reduced to fit these sort of investments, but this doesn’t mean we cannot examine alternatives. Ultimately, one’s investment objectives aren’t really subjective at all, they are objective, to make as much money as possible within certain risk tolerances.
If one happens to be satisfied with modest returns, for instance with what can be achieved with certificates of deposit, this doesn’t mean that we have optimized the plan to best align with the person’s objectives, as of course they would prefer higher returns even if they can get by with smaller ones.
We could even just take investment objectives as a given, and just look to rationality for the answer here, which would be profit maximization under certain constraints of risk. This is an assumption we make in business for instance, we don’t ask business owners how much money they wish to make, because the answer is obvious, they want to maximize profit.
This is Really All Driven By One’s Strategies
Whether or not one would want to invest in a risky business though is another matter, and there may be higher profit potential here but higher risk.
We can’t just look at risk in isolation of course, because the potential for profit will matter here as well. You could place a bet on the spin of a roulette wheel, and you may know that there is about a 50/50 chance of winning or losing, but how much you get when you win versus how much you lose is going to have to be known before you can make an informed decision on whether to take the bet.
If you win twice as much as you lose with this bet, you might want to take it, but if losing means that you lose your life savings and have to live out of a cardboard box, even this seemingly sweet deal might not look so good.
This all may seem overwhelming to many individual investors, many of whom want to strive for as much simplicity in their investments, and managing one’s own portfolio can seem pretty daunting at times, although it doesn’t have to be.
Determining one’s investment objectives should not be difficult though, as we’re just seeking to make as much money from our investments in a way that is comfortable for us. The risk side sets the limitations, within the strategy we use, and beyond that, the task becomes to seek out the best strategy that will deliver the most money fairly comfortably.
Coming up with good strategies is therefore the centerpiece of portfolio management, one that strives for profit while managing risk, and pays enough attention to both. What one may be satisfied with may play a role here, but what one may be able to achieve should be what drives things.