By: Robert R. Shaw
While not common today, some institutions maintain a return target* in their investment policy statements. This may be a mistake that militates against long-term goals.
Holding advisors or managers accountable to a return target can create perverse incentives that result in a portfolio with the wrong amount of risk. For the sake of the arguments below, assume that managers are assessed annually and that the “right” portfolio is one that appropriately balances various types of risk such as market, volatility, inflation, etc.
Too Much Risk
Imagine an economic climate in which expected returns for the year are low across the board. Decision makers who live or die by meeting a return target would naturally be incented to take more risks if they believe that their otherwise properly balanced portfolio cannot make the grade. Keeping the “right” portfolio may be likely to get them fired for underperformance. Therefore, why not shift toward assets with higher potential near-term rewards and a chance to clear the hurdle?
Not Enough Risk
On the other hand, imagine an expansionary climate in which the “right” portfolio has already exceeded its return target halfway into a given year. The same decision makers might want to “take some chips off the table” and ride out the rest of the year with a more conservative asset allocation. This may reduce volatility risk while adding excessive inflation risk.
A Better Idea
In both examples, the problem is discord between short-term incentives and long-term goals. A better idea is to choose an asset allocation according to risk tolerance, then compare the portfolio’s performance to appropriate benchmarks over time.
*A return target is not to be confused with a return assumption, which may be required for actuarial purposes. The crucial difference is that a return target influences asset allocation, while a return assumption is an estimate based on a certain asset allocation.
Robert R. Shaw is an investment consultant in Charlotte, NC. Robert creates tailored investment portfolios for institutions and wealthy families together with comprehensive plans for lasting financial success. Click here to learn more about Robert and how he can help you.
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