When inflation to cover is higher than the general inflation in the economy , ability to take risk higher or lower?
Risk tolerance - lower. Explanation: Your required return would be higher due to higher inflation in the OpEx. You have less ability to ride through volatility associated with riskier portfolio allocations.
I think you can justify like this as well.
If inflation increases then the return requirement must increase. (1+Spend)x(1+fees)x(1+inflation) If the return requirement increases then the endowment must increase risk to reach the requirement.
I disagree with this logic. For example, if you’re an underfunded DB Pension plan, your risk tolerance would be low because you’re underfunded and you can’t afford to lose asset base due to short term volatility. If you’re overfunded, your risk tolerance is higher because you can actively manage the surplus in riskier ventures while immunizing the A/L balance, such that even if your risky investments tank you’re still covered. Just because you need a higher return (because you’re underfunded, or your spending needs have gone up) doesn’t make your risk tolerance go up. Another example is let’s say you’re a spoilt rich brat who just bought a Ferrari and took on a big mortgage on a mansion. Your expenses have just gone up, but that doesn’t mean your ability or risk tolerance has also gone up. They’d have to explicitly say that the willingness to take risk has gone up (and even then, a prudent financial advisor would err on the side of caution). Similarly, if a foundation’s spending needs go up, it doesn’t mean it’s risk tolerance is higher. The need to take more risk is totally different from willingness/ability to take risk.
I found in the curriculum nothing about the direct link between inflation and foundations’ ability to take risk.
I think inflation directly affects on the return objective of the foundation, but not the foundations’ ability to take risk. Foundations’ ability to take risk is the highest among institutional investors.
what can in general increase in inflation do to ability to take risk for foundation ?