Since Harry Markowitz developed fashionable portfolio concept’s mean-variance optimization (MVO), monetary advisors and wealth managers have been confronted with a vital query: What’s the relative significance of threat tolerance (the investor’s perspective towards threat) in comparison with threat capability (the investor’s capacity 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 web 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 perform) of mean-variance optimization is to maximise the anticipated return of a portfolio, minus a personalised penalty for the anticipated threat (variance) of the portfolio. Personalised penalty is the investor’s threat tolerance coefficient multiplied by the variance of the portfolio.
In MVO, the “threat tolerance” coefficient is a single quantity reflecting the speed at which the investor is keen to commerce off extra threat in pursuit of extra anticipated return. Figuring out the investor’s threat 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, threat tolerance is clearly associated to the investor’s perspective towards threat, not threat capability.
Advisors regularly have a deep understanding of their purchasers’ conditions. This may embrace info on extra accounts, spousal belongings, compensation info, mortgage funds, and many others. Some purchasers could also be very comfy with threat, however with little capability for adversarial outcomes given their circumstances. Whereas different purchasers are extraordinarily uncomfortable with threat however can tolerate adversarial outcomes with little influence on their monetary well-being. Advisors discover themselves navigating what has been a extremely subjective threat tolerance (perspective) versus threat capability conundrum.
Two Approaches to Danger Capability
Pragmatically, there have been two approaches that explicitly deal with threat capability.
The primary strategy is a standard function of the “scoring” element of threat tolerance questionnaires. When scoring the responses to a threat tolerance questionnaire, there are regularly two scores: a threat tolerance rating and a time horizon rating. The time horizon rating serves as a crude proxy for the investor’s capability to tackle threat 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 finest represented by the “discretionary wealth speculation” primarily put forth by Jarrod Willcox.[1] In these kinds of approaches, the investor’s perspective towards threat 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 “threat tolerance coefficient. I take advantage of quotes to tell apart this from the financial definition of threat tolerance as an perspective.
Web Price Optimization (NWO)
In our 2024 CFA Institute Analysis Basis guide, “Lifetime Monetary Recommendation,” Kaplan and I put forth NWO. It’s a vital extension of MVO. NWO consists of the entire investor’s belongings and labilities within the optimization, particularly human capital, and it optimizes the investor’s holistic financial stability sheet.
An investor’s financial stability sheet consists of all his or her belongings — residence, land, collectables, and all monetary belongings. Most significantly, the financial stability sheet consists of the capitalized worth of the investor’s lifetime of earnings — human capital. For many individuals, the mortality weighted web current worth of all future labor earnings, together with deferred labor earnings within the type of outlined advantages and social safety, is their single largest asset.
The lifetime of money flows stemming from human capital is regularly paying homage to the money flows you’ll obtain from a big, inflation-linked, long-duration bond. Others have much less regular human capital which may resemble a inventory/bond combine.
On the right-side of an financial stability sheet, all of us have ongoing bills, reminiscent of hire, a mortgage, insurance coverage, medical prices, and meals. Whereas these might not be 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 vital indicator of an organization’s monetary well being, a holistic particular person financial stability sheet is a wonderful indicator of the investor’s general monetary well being and capability for taking over threat. The distinction between the whole worth of all belongings and all liabilities is web price. Therefore the time period web price optimization or NWO.
NWO consists of all the key 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’t change the web current worth of both. These nontradeable belongings 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 annually 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 might mannequin this individual’s human capital as practically 2/3rds long-duration-inflation-adjusted company bonds with a period similar to the 20 years of money flows, and practically 1/3rd mid-cap shares (reflecting the scale of the corporate).
You can refine the 1/3rd mid-cap shares by modeling them based mostly on the pharmaceutical sector and even utilizing the particular inventory in query. The present web current worth of social safety isn’t price that a lot as we speak, but it surely 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 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 absolutely accounts for the investor’s capacity to tackle threat.
Transferring by way of time life occurs. The shopper could possibly be fired, the worth of inventory might go up/down, inflation might enhance/lower, begin a household, or an uninsured residence on the coast could possibly be washed away, and many others. Critically, as the worth of the individual’s belongings relative to the worth of liabilities evolves, the individual’s monetary well being and skill to tackle threat evolve. Not like asset-only MVO, NWO absolutely captures the investor’s capacity to tackle threat.
In a February 2025 Monetary Planning Overview article, “Web Price Optimization,” Kaplan and I talk about greater than 8,000 web price optimizations during which we various 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 threat tolerance, the quantity of fairness publicity for tradable monetary belongings elevated with the relative power of the investor’s financial stability sheet. We consider it is a new, however intuitive end result.
Determine 1: Optimum Monetary Capital Fairness Stage.
Supply: Idzorek and Kaplan (2025).
In Determine 1, every dot is the common fairness degree of monetary capital from 180 web price optimizations similar to totally different mixtures of human capital and threat tolerance. Because the holistic financial stability sheet strengthens, all else equal, it’s optimum to tackle extra threat.
Conundrum Solved
With NWO there isn’t a conundrum. We now not must ask which is extra vital, the shopper’s perspective towards threat or the shopper’s capability to tackle threat.
NWO means that you can use the shopper’s threat tolerance because it was meant — to mirror the shopper’s perspective towards threat. Most significantly, NWO concurrently goes effectively past the time horizon proxy of threat capability by absolutely reflecting the shopper’s capacity to tackle threat as captured by a holistic and evolving financial stability sheet.
With the development of web price 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 Personalised Optimum Multi-Stage Method. Charlottesville, VA: Analysis Basis of CFA Institute. https://rpc.cfainstitute.org/websites/default/information/-/media/paperwork/article/rf-brief/lifetime-financial-advice.pdf
Idzorek, Thomas M., and Paul D. Kaplan. 2025. “Web Price Optimization.” Monetary Planning Overview 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 Take into account 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 Non-public Traders. Charlottesville, VA: Analysis Basis of CFA Institute.
[1] Examples embrace Wilcox (2003), Wilcox, Horvitz, and di Bartolomeo (2006), and Wilcox and Fabozzi (2009).
