The first step in the portfolio management process is to specify the investment policy which summarizes the objectives, constraints and preferences of the investor. The investment policy may be expressed as follows:
1. Return requirements
2. Risk tolerance
Constraints and Preferences
2. Investment horizon
5. Unique circumstances
The commonly stated investment goals are:
1. Income: To provide a steady stream of income through regular interest/dividend payment.
2. Growth: To increase the value of the principal amount through capital appreciation.
3. Stability: To protect the principal amount invested from the risk of loss.
Since income and growth represent two ways by which return is generated and stability implies containment or even elimination of risk, investment objectives may be expressed more succinctly in terms of return and risk. As an investor, you would primarily be interested in a higher return (in the form of income and/or capital appreciation) and a lower level of risk. However, return and risk typically go hand in hand. So you have to ordinarily bear a higher level of risk in order to earn a higher return. How much risk you would be willing to bear to seek a higher return depends on your risk disposition. Your investment objective should state your preferences or return relative to your distaste for risk.
You can specify your investment objectives in one of the following ways:
1. Maximize the expected rate of return, subject to the risk exposure being held within a certain limit (the risk tolerance level).
2. Minimize the risk exposure, without sacrificing a certain expected rate of return (the target rate of return).
Which of these two should you adopt? My recommendation is for you to start by defining how much risk you can bear or how much you can afford to lose, rather than specifying how much money you want to make. The risk you can bear depends on two key factors: (1) your financial situation, and (2) your temperament. To assess your financial situation, answer the following questions. What is the position of your wealth? What major expenses (house construction, marriage, education, medical treatment etc) can be anticipated in the near future? What is your earning capacity? How much money can you lose without seriously hurting your standard of living? A careful and realistic appraisal of your assets, expenses, and earnings is basic to defining your risk tolerance.
After appraising your financial situation, assess your temperamental tolerance for risk. Even though financial situation may permit you to absorb easily, you may become extremely upset over small losses. On the other hand, despite a not-so-strong financial position, you may not be easily ruffled by losses. Understand your financial temperament as objectively as you can.
Your risk tolerance level is set by either your financial situation or your financial temperament, whichever is lower. Of course, you must realize that your risk tolerance cannot be or should not be defined too precisely and rigorously. For practical purposes, it suffices if you define it as low, medium or high. Once you have articulated your risk tolerance realistically in this fashion, it will serve as a valuable guide in your investment selection. It will provide you with a useful perspective and prevent you from being a victim of the waves and manias that tend to sweep the market from time to time.
Financial advisers, mutual funds, and brokerage firms have developed risk questionnaires to help investors determine whether they are conservative, moderate or aggressive. Typically such risk questionnaires have 7 to 10 questions to gauge a person’s tendency to make risky or conservative choices in certain hypothetical situations. While these risk questionnaires are not precise, they are helpful in getting a rough idea of an investor’s risk tolerance.