CFA Level I Exam · Basics of Portfolio Planning and Construction

Risk and Return Objectives in the Investment Policy Statement

Updated 7 October 2026 · Fact-checked

Risk and return objectives are the two parts of an IPS that state how much return a client needs and how much risk the client can and will accept. You set the return goal from the client's needs, then set risk tolerance as the lower of ability and willingness to take risk.

Understand Risk and Return Objectives

An investment policy statement (IPS) turns a client's situation into rules for managing the portfolio. The return objective and the risk objective sit side by side. The return objective says what the portfolio must earn. The risk objective says how much loss and volatility is acceptable on the way.

Return objectives can be absolute or relative. An absolute objective is a fixed number, such as a 6% annual return or a nominal return that covers 3% inflation plus a 3% spending rate. A relative objective is measured against a benchmark, such as beating a global equity index by 1% a year. The return can also be stated before or after tax, and nominal or real. Always check which one the question uses.

Return goals also differ in purpose. A required return is the return needed to meet a goal, such as funding retirement spending. A desired return is what the client would like but does not need. A required return can be calculated. A desired return is a preference. The required return should come first, and it should be realistic given the risk the client can take.

Risk tolerance has two parts. Ability to take risk is objective. It depends on wealth, income stability, time horizon, liquidity needs, and obligations. Willingness to take risk is subjective. It depends on the client's attitudes, experience, and psychology, often measured by questionnaires and conversation. A client can be willing but unable, or able but unwilling.

When the two disagree, the adviser should use the more conservative one. A client with a large portfolio and a long horizon may have high ability, but if the client loses sleep over a 10% drop, willingness is low, so overall tolerance is below average. The reverse also holds: a keen risk-taker with a short horizon and tight liabilities has low ability, so overall tolerance is low.

Risk objectives are also absolute or relative. Absolute risk objectives state a maximum loss or volatility, such as no more than a 10% loss in any year, or a standard deviation below 12%. Relative risk objectives compare to a benchmark, such as tracking error under 2% a year. Institutions often use relative measures. Individuals more often use absolute ones.

Key formulas to remember

Overall risk tolerance: Overall risk tolerance = the lower of (ability, willingness); If ability is low and willingness is high, the client's tolerance is low. Use the more conservative of the two.
Required nominal return (approximate): Required return ≈ real spending rate + inflation (+ fees and taxes if stated); Exact form: (1 + real) × (1 + inflation) − 1. Use the approximation only if the question allows it.
Tracking error (relative risk): Tracking error = standard deviation of (portfolio return − benchmark return); This is the usual measure of a relative risk objective.
Active return (relative return): Active return = portfolio return − benchmark return; A relative return objective is stated as a margin above the benchmark.

How to solve Risk and Return Objectives questions

Use this method for any question on setting return and risk objectives for a client.

1Read the client facts and separate them into needs (spending, goals, liabilities) and attitudes (comfort with losses, experience).
2Identify the return objective: is it required or desired, absolute or relative, nominal or real, pre-tax or after-tax?
3If a calculation is needed, combine the spending rate, inflation, and any fees or taxes. Use the exact formula if the numbers are large.
4Judge ability to take risk from objective facts: wealth, income stability, time horizon, liquidity needs, and dependants.
5Judge willingness to take risk from subjective facts: stated attitudes, past reactions to losses, and investment knowledge.
6Take the lower of ability and willingness as overall risk tolerance.
7State the risk objective in absolute terms (maximum loss or volatility) or relative terms (tracking error), matching the facts given.
8Eliminate any option that mixes up ability with willingness, or that sets a risk level above the more conservative one.

Quickest way: Two-column test: Can vs Will

When to use it: Use this for qualitative questions asking whether a client's risk tolerance is above average, below average, or about average.

Write A for ability and W for willingness.
Mark each as high or low from the facts. Facts about money, time and obligations go to A. Facts about feelings and experience go to W.
Overall tolerance equals the lower mark.
Pick the option that matches. Drop options that follow the higher mark or average the two without reason.

Common mistakes in Risk and Return Objectives

Averaging ability and willingness
It feels fair to split the difference.
Fix: Use the more conservative of the two. The IPS risk tolerance is the lower one.
Treating a young age or long horizon as willingness
Students link youth with boldness.
Fix: Horizon, income and wealth are ability factors. Willingness is about attitude and behaviour.
Confusing required and desired return
Both sound like goals.
Fix: Required return is needed to meet a goal. Desired return is a wish. Build the objective on the required return.
Mixing real and nominal returns
Inflation is mentioned in the facts but not applied.
Fix: If a goal is stated in real terms, add inflation to get the nominal return. Check whether taxes also apply.
Calling tracking error an absolute risk measure
It is a standard deviation, so it looks like absolute volatility.
Fix: It is the standard deviation of active return against a benchmark, so it is a relative risk measure.
Ignoring the link between return and risk
Students treat the two objectives separately.
Fix: If the required return needs more risk than the client's tolerance allows, the objectives conflict. The adviser must flag it and revisit the goal.

Worked examples

Example 1

A 38-year-old engineer has a stable job, no debts and a large portfolio relative to spending needs, so her ability to take risk is high. In meetings she says she would sell everything after a 5% fall and has never invested in equities. Which describes her overall risk tolerance? A. Below average B. Average C. Above average

Show the solution

Ability: high, from stable income, no debt, large portfolio.
Willingness: low, from selling after a 5% fall and no equity experience.
Overall tolerance is the lower of the two, which is low.
Averaging or using ability would be the trap answers.

Answer: A. Below average

Example 2

A foundation must spend 4% of assets each year and expects inflation of 2.5%. Ignoring fees and taxes, what is its required nominal return using the exact formula? A. 6.50% B. 6.60% C. 6.70%

Show the solution

Real return needed = 4% = 0.04.
Inflation = 2.5% = 0.025.
Nominal = (1.04 × 1.025) − 1 = 1.066 − 1 = 0.066.
That is 6.60%. The simple sum is 6.50%, which is the approximation trap.

Answer: B. 6.60%

Exam tips

Look for facts that belong to ability (time, wealth, liabilities) and willingness (attitude, experience). The question often hides one in the facts.
When two options differ only by one word such as above or below average, check which factor is the lower one.
Read return objectives for real versus nominal and pre-tax versus after-tax before calculating.
Numerical options run smallest to largest. If the exact formula and the simple sum give different answers, expect both among the options.
With no penalty for wrong answers, always answer. Eliminating the averaging option usually leaves two choices.

Practice questions from Basics of Portfolio Planning and Construction

Risk and Return Objectives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CFA Level IIIRisk Tolerance: Willingness and Ability to Take Risk

Risk and Return Objectives: frequently asked questions

What is the difference between ability and willingness to take risk?

Ability is objective. It depends on wealth, income, horizon, and liabilities. Willingness is subjective. It depends on the client's attitudes and psychology. The IPS uses the lower of the two.

What is the difference between absolute and relative risk objectives?

An absolute objective sets a limit not tied to any benchmark, such as a maximum annual loss or volatility. A relative objective is measured against a benchmark, such as tracking error. Individuals often use absolute objectives, and institutions often use relative ones.

How do you set a return objective in an IPS?

Start with the client's needs, such as spending and inflation, and state whether the return is real or nominal, pre-tax or after-tax. Then separate the required return from the desired return. Check that the required return is achievable within the client's risk tolerance.

How is risk tolerance assessed for an investor?

The adviser looks at objective facts for ability and uses questionnaires and discussion for willingness. The two are compared, and the more conservative one sets the overall tolerance.