Key Points:
- Clear communication is crucial in the investment process to ensure that investment objectives and risks are understood and addressed.
- New decision metrics called Portfolio Pi and Portfolio Eta have been developed to directly connect objectives and risks and help decision makers make trade-offs.
- Portfolio Pi is a measure of the probabilities of achieving desired objectives and avoiding specific losses, while Portfolio Eta summarizes the economic value differences between portfolios with different Pi Scores.
- Investment committees need to consider both attainable objectives and risk capacity in order to evaluate investment strategies effectively.
Summary:
In this article, we explore the importance of clear communication in the investment process and introduce new decision metrics, Portfolio Pi and Portfolio Eta. These metrics, developed by Jakša Cvitanić and Karyn Williams, allow decision makers to make direct trade-offs among competing objectives and help ensure that the chosen investment strategy best serves its purpose.
Portfolio Pi is a weighted average of the probabilities of attaining desired investment objectives, including avoiding specific losses, over an investment horizon. It summarizes an investment portfolio’s potential to achieve objectives and avoid losses. Portfolio Eta, on the other hand, represents the economic value that an investor potentially stands to gain or lose between portfolios with different Pi Scores. It fully summarizes the differences between portfolios’ returns, risks, and costs.
By using shared language that is meaningful for investors and considering both attainable objectives and risk capacity, investment committees can effectively evaluate investment strategies. It is essential to determine the available financial resources that the investment portfolio can lose without impairing the institution’s purpose. This risk-capacity information helps evaluate an investment strategy by assessing the average probabilities of hitting the target-return objective annually and not violating the loss limit over the next five years.
The article also provides examples of how Portfolio Pi and Portfolio Eta can be applied in practice. It presents the probabilities of achieving the target-return objective and the loss limit for different investment portfolios under various distribution assumptions. It emphasizes the importance of communicating probabilities and trade-offs to investors and highlights the need to translate potential outcomes into dollar terms.
While these metrics do not provide definitive answers, they help contextualize investment concepts and facilitate communication among stakeholders, ensuring a more disciplined decision-making framework. By using a common language and agreed-upon preferences, investors can make more informed choices and protect the purpose of their investment assets.
Adapted from “Communicating Clearly about Investment Objectives and Risks” by Karyn Williams, PhD, and Harvey D. Shapiro in Investments & Wealth Monitor.
