Since Harry Markowitz developed fashionable portfolio idea’s mean-variance optimization (MVO), monetary advisors and wealth managers have been confronted with an important query: What’s the relative significance of danger tolerance (the investor’s angle towards danger) in comparison with danger capability (the investor’s capacity to endure adverse outcomes)?
I have to confess that I’ve been perplexed by this query for many years. My frequent co-author, Paul Kaplan, and I imagine now we have solved this 50+ yr conundrum utilizing an expanded MVO optimization mannequin referred to as internet price optimization (NWO).
I plan to debate our findings on my panel at CFA Institute LIVE 2025 in Chicago in Could.
How did we get right here?
The aim (goal operate) of mean-variance optimization is to maximise the anticipated return of a portfolio, minus a customized penalty for the anticipated danger (variance) of the portfolio. Customized penalty is the investor’s danger tolerance coefficient multiplied by the variance of the portfolio.
In MVO, the “danger tolerance” coefficient is a single quantity reflecting the speed at which the investor is keen to commerce off extra danger in pursuit of extra anticipated return. Realizing the investor’s danger tolerance coefficient permits you to clear up for the corresponding MVO environment friendly portfolio.
Within the economics literature and the works of Nobel Prize winners like Paul Samuelson, danger tolerance is clearly associated to the investor’s angle towards danger, not danger capability.
Advisors continuously have a deep understanding of their shoppers’ conditions. This would possibly embrace data on further accounts, spousal property, compensation data, mortgage funds, and many others. Some shoppers could also be very comfy with danger, however with little capability for hostile outcomes given their circumstances. Whereas different shoppers are extraordinarily uncomfortable with danger however can tolerate hostile outcomes with little influence on their monetary well-being. Advisors discover themselves navigating what has been a extremely subjective danger tolerance (angle) versus danger capability conundrum.
Two Approaches to Danger Capability
Pragmatically, there have been two approaches that explicitly give attention to danger capability.
The primary strategy is a standard characteristic of the “scoring” element of danger tolerance questionnaires. When scoring the responses to a danger tolerance questionnaire, there are continuously two scores: a danger tolerance rating and a time horizon rating. The time horizon rating serves as a crude proxy for the investor’s capability to tackle danger that limits which portfolios are deemed appropriate.
The second strategy might be much less recognized to practitioners however prevalent within the practitioner-oriented literature. This strategy is greatest represented by the “discretionary wealth speculation” primarily put forth by Jarrod Willcox.[1] In these kind of approaches, the investor’s angle towards danger is discounted or ignored, and monetary ratios just like the ratio of assets-to-liabilities are used as the first issue to estimate a so-called “danger tolerance coefficient. I take advantage of quotes to tell apart this from the financial definition of danger tolerance as an angle.
Web Value Optimization (NWO)
In our 2024 CFA Institute Analysis Basis e-book, “Lifetime Monetary Recommendation,” Kaplan and I put forth NWO. It’s a important extension of MVO. NWO contains all the investor’s property and labilities within the optimization, particularly human capital, and it optimizes the investor’s holistic financial stability sheet.
An investor’s financial stability sheet contains all his or her property — house, land, collectables, and all monetary property. Most significantly, the financial stability sheet contains the capitalized worth of the investor’s lifetime of earnings — human capital. For many individuals, the mortality weighted internet current worth of all future labor revenue, together with deferred labor revenue within the type of outlined advantages and social safety, is their single largest asset.
The lifetime of money flows stemming from human capital is continuously paying homage to the money flows you’d obtain from a big, inflation-linked, long-duration bond. Others have much less regular human capital that may resemble a inventory/bond combine.
On the right-side of an financial stability sheet, all of us have ongoing bills, equivalent to lease, a mortgage, insurance coverage, medical prices, and meals. Whereas these is probably not authorized liabilities, these bills are sometimes inescapable. Collectively, their capitalized values kind what we consider because the investor’s nondiscretionary consumption legal responsibility.
Simply as a stability sheet is a crucial indicator of a company’s monetary well being, a holistic particular person financial stability sheet is a wonderful indicator of the investor’s total monetary well being and capability for taking over danger. The distinction between the whole worth of all property and all liabilities is internet price. Therefore the time period internet price optimization or NWO.
NWO contains all the foremost financial stability sheet entries. Nontradable entries — the investor’s human capital and nondiscretionary consumption legal responsibility — are included within the optimization, though the optimizer can not change the web current worth of both. These nontradeable property are modeled as portfolios of asset courses, which allow us to derive correct market-based low cost charges and perceive how they work together with the remainder of the stability sheet.
Think about a 45-year outdated pharmaceutical scientist with a base wage of $200,000, adjusted every year for inflation, who receives $100,000 nominal restricted inventory items with a five-year vesting schedule who additionally expects to obtain roughly $25,000 per yr from social safety beginning at age 65. One may mannequin this individual’s human capital as almost 2/3rds long-duration-inflation-adjusted company bonds with a period equivalent to the 20 years of money flows, and almost 1/3rd mid-cap shares (reflecting the scale of the corporate).
You possibly can refine the 1/3rd mid-cap shares by modeling them based mostly on the pharmaceutical sector and even utilizing the precise inventory in query. The present internet current worth of social safety isn’t price that a lot right now, however it too ought to be accounted for correctly. The anticipated returns on every kind the premise for a weighted common value of capital for calculating the worth of the scientist’s human capital.
The capitalized worth of the investor’s nondiscretionary consumption legal responsibility, which is considerably like issuing a long-duration-inflation-linked bond with outgoing coupon funds, is included as a nontradable adverse holding within the optimization.
Then within the presence of nontradable property and liabilities NWO determines the optimum asset allocation for the investor’s tradable property — an optimization that absolutely accounts for the investor’s capacity to tackle danger.
Transferring by way of time life occurs. The consumer could possibly be fired, the worth of inventory may go up/down, inflation may improve/lower, begin a household, or an uninsured house on the coast could possibly be washed away, and many others. Critically, as the worth of the individual’s property relative to the worth of liabilities evolves, the individual’s monetary well being and skill to tackle danger evolve. In contrast to asset-only MVO, NWO absolutely captures the investor’s capacity to tackle danger.
In a February 2025 Monetary Planning Evaluation article, “Web Value Optimization,” Kaplan and I talk about greater than 8,000 internet price optimizations during which we diversified the investor’s human capital and the composition of the investor’s financial stability sheet. As Determine 1 reveals, after controlling for the investor’s danger tolerance, the quantity of fairness publicity for tradable monetary property elevated with the relative energy of the investor’s financial stability sheet. We imagine it is a new, however intuitive consequence.
Determine 1: Optimum Monetary Capital Fairness Degree.
Supply: Idzorek and Kaplan (2025).
In Determine 1, every dot is the common fairness stage of economic capital from 180 internet price optimizations equivalent to totally different combos of human capital and danger tolerance. Because the holistic financial stability sheet strengthens, all else equal, it’s optimum to tackle extra danger.
Conundrum Solved
With NWO there isn’t any conundrum. We now not have to ask which is extra necessary, the consumer’s angle towards danger or the consumer’s capability to tackle danger.
NWO permits you to use the consumer’s danger tolerance because it was supposed — to replicate the consumer’s angle towards danger. Most significantly, NWO concurrently goes nicely past the time horizon proxy of danger capability by absolutely reflecting the consumer’s capacity to tackle danger as captured by a holistic and evolving financial stability sheet.
With the development of internet price optimization, the monetary planning business ought to transfer from MVO to NWO.
References
Idzorek, Thomas M., and Paul D. Kaplan. 2024. Lifetime Monetary Recommendation: A Customized Optimum Multi-Degree Method. Charlottesville, VA: Analysis Basis of CFA Institute. https://rpc.cfainstitute.org/websites/default/recordsdata/-/media/paperwork/article/rf-brief/lifetime-financial-advice.pdf
Idzorek, Thomas M., and Paul D. Kaplan. 2025. “Web Value Optimization.” Monetary Planning Evaluation 8 (1): e1200. https://onlinelibrary.wiley.com/doi/epdf/10.1002/cfp2.1200
Straehl, Philip U., Robert ten Brincke, and Carlos Gutierrez Mangas. 2024. “Ought to Your Inventory Portfolio Contemplate Your Profession?” Morningstar Analysis Paper, June 21.
Wilcox, Jarrod W. 2003. “Harry Markowitz and the Discretionary Wealth Speculation.” Journal of Portfolio Administration 29 (3): 58 – 65. DOI: 10.3905/jpm.2003.319884
Wilcox, Jarrod W., and Frank J. Fabozzi. 2009. “A Discretionary Wealth Method for Funding Coverage.” Journal of Portfolio Administration 36 (1): 46-59. DOI: 10.3905/JPM.2009.36.1.046
Wilcox, Jarrod W., Jeffrey E. Horvitz, and Dan DiBartolomeo. 2006. Funding Administration for Taxable Personal Buyers. Charlottesville, VA: Analysis Basis of CFA Institute.
[1] Examples embrace Wilcox (2003), Wilcox, Horvitz, and di Bartolomeo (2006), and Wilcox and Fabozzi (2009).
