Establishing and understanding the risk tolerance of an organization’s investment leadership body are critical to avoid investment losses that can negatively impact the mission of the organization.


In the wake of the financial crisis, trustees of many institutions—healthcare organizations included—have realized that their portfolio was riskier than intended and that their trustees’ ability to tolerate loss wasn’t as strong as perceived. What can board leaders do about it? 

The risk tolerance of a board or investment committee is one of the most important items to consider in framing investment policy. It is usually addressed in some fashion in the investment policy statement. But all too often, risk tolerance is handled in a summary or conceptual fashion by statements that refer only to “acceptable” or “prudent” levels of risk without inquiry into the specific risks that the proposed investment goals and portfolio structure would incur. The result is that trustees find themselves ruefully looking back at how their “risk management” system could have failed them in a market downturn. Only with the clarity of 20/20 hindsight do they realize that the risk in their portfolio exceeded the board’s intended level; an asset allocation or investment strategy that once looked safe suddenly is a source of uncertainty.

How can committees overcome their vulnerability to risks that exceed their tolerance? And what guidelines should committees follow when framing investment policy? Specific steps can mitigate losses that are severe enough to impair the institution’s mission, or from which it takes an unacceptably long period for the organization to recover.

Understanding the Importance of Risk

Broadly defined, risk tolerance is an institution’s ability or willingness to weather large—or larger than anticipated—losses in portfolio values. The factors that can cause these losses include market action, economic contraction, inflation, deflation, interest rate changes, and geopolitical events. Risk tolerance is usually considered in relation to the variables surrounding investment choices and investment policy. Although other types of risk, such as liquidity risk, strategic risk, operational risk, credit or counterparty risk, byproduct risk, and balance sheet risk, also may cause losses, they are usually considered as by-products of primary investment-related decisions.a

Two central building blocks of an investment policy statement are asset allocation and spending policy; both play a role in risk management. Asset allocation is insufficiently valued as a determinant of investment success by many fiduciaries, who frequently behave as if selecting the “right” manager were more important. In fact, the classic Brinson/Hood/Beebower study, which has been supported by academic and market evidence since its publication in 1986,b demonstrated that over 90 percent of the variation in a portfolio’s return is due to asset allocation policy rather than to manager selection. Closely following asset allocation in importance are spending policy and spending method. Institutions should design their spending and calculate their spending levels to balance the needs of the present with the needs of the future while limiting the year-to-year volatility of spending.

But markets can upset even the wisest investment committee’s good intentions and carefully crafted policies. In 2008, the average annual total return on investable assets for the 143 not-for-profit healthcare organizations participating in the Commonfund Benchmarks Study® of Healthcare Organizations was -21.2 percent (net of fees). After such a painful year, more than a few investment committees voted to go to cash in February 2009 just before equities staged a major rally that drove the S&P 500 Index 26.5 percent higher by year end.

Behavioral or psychological factors enter prominently into investment decision-making, and understanding those factors starts with an assessment of the board’s temperament—that is, what its susceptibility is to swings between extremes of fear and exuberance. The overall makeup of the board and the backgrounds of its members often will shape its temperament. 

One well-researched source of exuberance is a phenomenon known as optimism bias, which is a belief that an individual is less at risk for negative events than others. An example of optimism bias is the belief of some smokers that they are less likely to contract lung cancer than other smokers. Similarly, some traders might think they are less exposed to losses in the financial markets. 

Sources of fear could include worries that presiding over a period of deep portfolio loss will damage a person’s reputation or career. 

Assessing Risk Tolerance

What can a board or investment committee chair do to gain a realistic understanding of decision-makers’ risk tolerance and shape an appropriate policy?

A good starting point is to align risk tolerance with institutional objectives. The investment policy statement should be reviewed for consistency with the organization’s mission, objectives, and resources. The statement sets the overall risk control framework by addressing asset allocation and rebalancing. These broad policy guidelines can be reinforced or tested by the use of computer-generated stress tests and simulations that can indicate a portfolio’s probable reaction to a wide range of proposed financial scenarios. A second approach uses back testing to examine prior time periods to estimate how a given asset allocation or investment strategy may perform in the future, given a set of similar conditions. A third approach is to review extremely negative, “left tail” risk events that, while deemed highly unlikely, have serious consequences when they do occur.

Boards should take a long-term perspective to avoid ill-advised decisions in response to short-term market conditions. The long view to investing is accepted wisdom but it requires a commitment in advance to ensure agreement among board members. Key questions could include whether trustees are willing to risk underperforming institutional objectives for a short period of time (under one year) or whether they are willing to accept a longer period of poor returns (two or three years). Decision makers also should operate with a clear philosophy regarding market timing and tactical shifts in asset allocation. Research has largely discredited market timing, but active debate continues about tactical shifts, which may add as much as 1 percent annually, net of fees, to returns. Another key factor to determine due to its effect on comfort with risk is the board’s interest in adding value. For example, indexing all asset classes creates different sets of risks than active management that aims to add value and mitigate risk relative to an index.

The composition and leadership of the investment committee offer another opportunity to judge risk tolerance. Generally, committees benefit from a chair who is an experienced investor. But committee membership could benefit from a mix of investment experts and nonprofessionals. The value of differing backgrounds among committee members is subtle, but valuable. Committee meetings properly managed by the chair that include diverse views and backgrounds can be a source of strength. A committee dominated by homogeneity can have blind spots that can hamper its ability to optimize long-term returns for the organization. 

Shaping the committee over the long term is the responsibility of the board and committee chairs, who can envision the committee they need and then recruit to fill the vision. It is possible to reshape a committee relatively quickly—often in as little as two or three years through attrition and recruitment. That change can produce another opportunity to mold the committee through effective orientation of incoming committee members. Yet another tool for the chair is the committee’s agenda. Simply reducing the time devoted to meeting investment managers and instead spending significantly more time on investment policy will focus the committee on the larger, more important issues that ultimately shape long-term outcomes. 

In the end, understanding the board’s risk tolerance is a process—a matter of balancing policies, practices and people—so that in times of stress decision-makers are able to avoid reactions that are contrary to the organization’s long-term interest. 

William F. Jarvis is managing director, Commonfund Institute.


a. Byproduct risks can be substantial: The accounting , settlement, and transparency risks associated with Bernard Madoff's fraudulent investment operation were mostly byproduct risks, but were masked by Madoff's too-good-to-be-true investment results, his prestige, and his aura of inaccessibility.

b. Brinson, G.P., Hood, R., and Beehower, G.L., "Determinants of Portfolio Performance," Financial Analysts Journal, July/August, 1986.

Publication Date: Wednesday, January 01, 2014

Login Required

If you are an existing member, please log in below. Username and password are required.



Forgot User Name?
Forgot Password?

If you are not an HFMA member and would like to access portions of our content for 30 days, please fill out the following.

First Name:

Last Name:


   Become an HFMA member instead