Since Harry Markowitz developed fashionable portfolio concept’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 skill to endure unfavorable outcomes)?
I need to confess that I’ve been perplexed by this query for many years. My frequent co-author, Paul Kaplan, and I consider we’ve solved this 50+ yr conundrum utilizing an expanded MVO optimization mannequin known as internet value optimization (NWO).
I plan to debate our findings on my panel at CFA Institute LIVE 2025 in Chicago in Might.
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 personalised 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 prepared to commerce off extra danger in pursuit of extra anticipated return. Realizing the investor’s danger tolerance coefficient means that you can 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 incessantly have a deep understanding of their shoppers’ conditions. This may embrace data on extra accounts, spousal belongings, compensation data, mortgage funds, and many others. Some shoppers could also be very comfy with danger, however with little capability for antagonistic outcomes given their circumstances. Whereas different shoppers are extraordinarily uncomfortable with danger however can tolerate antagonistic outcomes with little impression 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 Threat Capability
Pragmatically, there have been two approaches that explicitly deal with danger capability.
The primary strategy is a typical characteristic of the “scoring” element of danger tolerance questionnaires. When scoring the responses to a danger tolerance questionnaire, there are incessantly 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 identified 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 all these 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 exploit quotes to differentiate this from the financial definition of danger tolerance as an angle.
Web Price Optimization (NWO)
In our 2024 CFA Institute Analysis Basis e-book, “Lifetime Monetary Recommendation,” Kaplan and I put forth NWO. It’s a vital extension of MVO. NWO contains the entire investor’s belongings and labilities within the optimization, particularly human capital, and it optimizes the investor’s holistic financial steadiness sheet.
An investor’s financial steadiness sheet contains all his or her belongings — dwelling, land, collectables, and all monetary belongings. Most significantly, the financial steadiness 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 incessantly paying homage to the money flows you’ll 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 steadiness sheet, all of us have ongoing bills, equivalent to hire, a mortgage, insurance coverage, medical prices, and meals. Whereas these is probably not authorized liabilities, these bills are sometimes inescapable. Collectively, their capitalized values type what we consider because the investor’s nondiscretionary consumption legal responsibility.
Simply as a steadiness sheet is a crucial indicator of a company’s monetary well being, a holistic particular person financial steadiness sheet is a superb indicator of the investor’s total monetary well being and capability for taking up danger. The distinction between the overall worth of all belongings and all liabilities is internet value. Therefore the time period internet value optimization or NWO.
NWO contains all the main financial steadiness sheet entries. Nontradable entries — the investor’s human capital and nondiscretionary consumption legal responsibility — are included within the optimization, though the optimizer can’t change the online current worth of both. These nontradeable belongings are modeled as portfolios of asset lessons, which allow us to derive correct market-based low cost charges and perceive how they work together with the remainder of the steadiness 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 models with a five-year vesting schedule who additionally expects to obtain roughly $25,000 per yr from social safety beginning at age 65. One might mannequin this particular person’s human capital as practically 2/3rds long-duration-inflation-adjusted company bonds with a period akin to the 20 years of money flows, and practically 1/third mid-cap shares (reflecting the scale of the corporate).
You could possibly refine the 1/third mid-cap shares by modeling them primarily based on the pharmaceutical sector and even utilizing the precise inventory in query. The present internet current worth of social safety isn’t value that a lot right this moment, but it surely too ought to be accounted for correctly. The anticipated returns on every type the idea 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 unfavorable holding within the optimization.
Then within the presence of nontradable belongings and liabilities NWO determines the optimum asset allocation for the investor’s tradable belongings — an optimization that totally accounts for the investor’s skill to tackle danger.
Shifting by time life occurs. The shopper could possibly be fired, the worth of inventory might go up/down, inflation might improve/lower, begin a household, or an uninsured dwelling on the coast could possibly be washed away, and many others. Critically, as the worth of the particular person’s belongings relative to the worth of liabilities evolves, the particular person’s monetary well being and talent to tackle danger evolve. In contrast to asset-only MVO, NWO totally captures the investor’s skill to tackle danger.
In a February 2025 Monetary Planning Evaluation article, “Web Price Optimization,” Kaplan and I talk about greater than 8,000 internet value optimizations during which we diverse the investor’s human capital and the composition of the investor’s financial steadiness sheet. As Determine 1 reveals, after controlling for the investor’s danger tolerance, the quantity of fairness publicity for tradable monetary belongings elevated with the relative energy of the investor’s financial steadiness sheet. We consider it is a new, however intuitive consequence.
Determine 1: Optimum Monetary Capital Fairness Stage.
Supply: Idzorek and Kaplan (2025).
In Determine 1, every dot is the typical fairness degree of economic capital from 180 internet value optimizations akin to totally different mixtures of human capital and danger tolerance. Because the holistic financial steadiness sheet strengthens, all else equal, it’s optimum to tackle extra danger.
Conundrum Solved
With NWO there is no such thing as a conundrum. We not have to ask which is extra essential, the shopper’s angle towards danger or the shopper’s capability to tackle danger.
NWO means that you can use the shopper’s danger tolerance because it was meant — to replicate the shopper’s angle towards danger. Most significantly, NWO concurrently goes properly past the time horizon proxy of danger capability by totally reflecting the shopper’s skill to tackle danger as captured by a holistic and evolving financial steadiness sheet.
With the development of internet value optimization, the monetary planning trade ought to transfer from MVO to NWO.
References
Idzorek, Thomas M., and Paul D. Kaplan. 2024. Lifetime Monetary Recommendation: A Customized Optimum Multi-Stage Strategy. 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 Price 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 Think about 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 Strategy 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 Traders. Charlottesville, VA: Analysis Basis of CFA Institute.
[1] Examples embrace Wilcox (2003), Wilcox, Horvitz, and di Bartolomeo (2006), and Wilcox and Fabozzi (2009).
