Geller Law
A useful summary from the CFA Institute " Establishing an investment risk profile (IRP) is an essential part of structuring an investor’s investment portfolio, and the IRP is an integral element of an investor’s investment policy statement. Financial advisors must use their best professional judgment to determine how investors can achieve financial goals through appropriate portfolio security selection. However, doing so requires balancing return objectives with the risk of variation in returns—in particular, the risk of negative returns...
An important financial advisory skill is the ability to develop a comprehensive representation of an investor’s IRP. A robust IRP measure provides a pathway to ensure that any proposed portfolio strategy is fit for the purpose with respect to achieving an investor’s goals. This requires careful analysis and synthesis of three dimensions of an IRP:
• An investor’s need for risk should be assessed by considering the required rate of return (RoR) on the investment portfolio to fulfill the investor’s future lifestyle, charitable, and dynastic goals. In concert with capital markets expectations, a calculated required portfolio RoR will suggest potential asset allocation strategies that align with market risks.
• An investor’s ability to take risk includes the investor’s time horizon, potential need for liquidity, and risk capacity. These factors will determine the investor’s financial ability to withstand declines in portfolio values. The ability to take risk can often be a limiting factor when considering an investor’s need for risk to meet corresponding goals.
• An investor’s behavioral loss tolerance can upset the most carefully devised quantitative portfolio strategy. Best practice is to use psychometric tools (often questionnaires) that have demonstrated reliability and validity in predicting an investor’s emotional and behavioral tendencies around loss of portfolio value and investing discipline. Having independently analyzed the three dimensions that comprise an IRP—risk need, risk-taking ability, and behavioral loss tolerance—the financial advisor must then reconcile these dimensions into a portfolio consistent with the investor’s IRP. This report proposes best practices with regard to investment risk profiling: Financial advisors should strive to combine straightforward calculations of risk need, careful assessment of risk-taking ability, and a robust examination of investor behaviors and attitudes to create the foundation for portfolio strategies and accompanying investment and financial planning decisions." [Emphasis Added]
