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 Investments & Wealth Monitor.1
Effective investment management requires clear communications. Everyone involved must understand the returns they are seeking and the risks they are shouldering. But the amorphous quality of some crucial investment concepts, particularly investment risk, often makes these communications hard to achieve.
In this first installment of our three-part series, we discuss the need for clear communications at the initial stage of the investment process and how objectives are the bedrock for basic investment strategy decisions.
The Setting
At any sizable institution, the investment process requires collaboration. The ideas and opinions of participants, from executives and board members to external investment managers and consultants, must be heard and evaluated even if they are not necessarily implemented. Extensive and intensive communication is essential.
In the investment world, however, communication is hard. 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 harder to define and grasp. 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 are understood when neither is the case.
The success or failure of these dialogues shapes significant decisions at every stage of the investment process.
From Purpose to Investment Objectives
For most sizable investment pools, the general purpose may seem clear enough. The money is there to generate funds to support charitable activities, secure retirement incomes, pay future insurance claims, or produce income for family members now or in the future.
Once the purpose is established, there must be a granular discussion of objectives to determine how financial resources should be invested to support that purpose. For example, a philanthropic foundation should establish specific program goals, because it can’t do everything for everybody.
Once the foundation commits to, say, supporting the arts, it must next establish how long it plans to exist. Should it give away all its money as fast as possible to meet critical needs in the arts and then go out of business? Or should it commit to supporting its mission in perpetuity? Either of these are reasonable choices, but if it’s the latter, the foundation must create a grant-making program supported by an investment program that ensures it lives within its means.
Decisions about which objectives to pursue involve difficult and sometimes painful conversations and investing’s vocabulary can sometimes conceal objectives or muddy the options. Moreover, such decisions are never one and done. Mid-course corrections are often necessary responses to changes in investment results or shifting 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 entirely different today than it was a century ago. These foundations have responded accordingly, modifying their purpose and investment objectives to adjust with the times and the evolving requirements of their mission. So periodically reconfirming purpose and regularly setting investment objectives are essential parts of the investment process.
A practical approach is to set investment objectives over continuous, or rolling, “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 following table shows typical components of target-return objectives over a five-year investment-planning horizon for a $50-million public foundation, a $100-million private foundation, and a $1-billion defined benefit pension plan.
Sample Five-Year Investment Return Objectives
| $50-Million Public Foundation | $100-Million Private Foundation | $1-Billion Defined Benefit Pension Plan | |
| Annual Expected 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 for setting its target-return objectives. A private foundation must pay out at least 5% annually to retain its tax-exempt status, but a defined benefit pension fund requires only an estimated payout and a public foundation may have substantial discretion in its spending. Nevertheless, each organization has a target-return objective for the five-year horizon, even if it expects to fulfill its purpose indefinitely.
Once investment return objectives are estimated, investors should go on to develop the investment strategy. Maximizing returns may seem reasonable as an objective, but that’s easier said than done. It can mean embracing substantial risk, which creates the potential for setbacks that constrain an organization’s ability to fulfill its goals.
This balancing act is further complicated by the lack of symmetry in the language of investing. Risk and return are investing’s yin and yang. Return measures are concrete and allow for meaningful comparisons across time and an array of portfolios. But risk is nebulous and hard to gauge. Is it volatility? Tracking error? Any decline in value? A cataclysmic drawdown? Doing something that others regard as stupid?
That’s why identifying the investment objectives and achieving stakeholder buy-in is the critical first step in connecting the objectives to portfolio construction. And that requires overcoming the inherent shortcomings of 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. Investments & Wealth Monitor is published by the Investments & Wealth Institute®.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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