On August 9, 2021, Helen Yang, CFA, founder and CEO of Andes Wealth Technologies, published an article titled “The Next Generation of Risk Measurement Methodology” in Advisor Perspectives.
In this article, Yang proposes a four-dimensional risk profile framework consisting of: risk tolerance, risk capacity, risk perception and risk composure. Yang also addresses common points of confusion:
- Is risk tolerance stable?
- How does the asset level affect the risk capacity?
- Does it make sense to add up risk tolerance and risk capacity?
- What causes the risk perception to change?
- Can risk composure be measured?
Click here to read the article.
Bob Veres, a thought leader and industry influencer, called this “an important article” in his Media Review. With permission, below is Bob Veres’ review of the article. If you wish to see more of Veres’ media reviews, please subscribe to his service at www.bobveres.com.
Veres’ review of the article below:
This is an important article. Advisors who are still relying on a simplistic risk tolerance model that scores clients with a single 1-100 risk number might want to take a look at how much of the client’s picture they’re actually missing.
The author, a former MIT Sloan Fellow, has developed her own risk profiling software (Andes Wealth Technologies) is attempting to formulate, for the profession, a more comprehensive risk profile framework by comparing the views of risk tolerance from Michael Kitces and Dr. Daniel Crosby, who helped create Orion’s 3D Risk Profile. They have suggested that in addition to risk tolerance, advisors need to look at risk capacity (whether the client is in a financial position to afford the downside possibilities), and risk composure (how likely the investor is to make irrational decisions during market turmoil). Kitces has talked about a fourth dimension: risk perception. When the markets go up, clients may perceive less risk in the market; during bear markets, they may believe there is more risk in the same investment composition.
Yang says that risk composure and risk perception are closely-related. And she proposes an “ultimate investor risk profile” that goes far beyond giving each client a “number.” Her four-dimensional model would start with risk tolerance, how much risk a client wants to take, although the Andes model is somewhat different from what thousands of advisors currently use; it uses capital market assumptions to show the spectrum of possible returns over any time period for every model portfolio the advisor is offering, out to an 80% confidence interval (1.28 standard deviations; advisors can bump that up to two standard deviations, 95% confidence interval if they wish). The client simply selects the range he or she feels most comfortable with (very defensible if there is ever a legal dispute).
Risk capacity can be viewed as a modification of risk tolerance; you start with how much risk the client is willing to take and adjust based on what the client can afford. As Yang says, this is really no different than buying a car or a house.
Risk perception and risk composure are fundamentally different. In an illustration in the article, the relationship is correlated rather than causal: market movements could trigger a change in risk perception, which might or might not change the client’s risk composure, which in turn might or might not trigger a client (emotional) response. Before you dismiss a client’s change in risk perception as irrational, check out one of Yang’s charts, which shows that since 2018, whenever the markets dropped, 3-month rolling volatility spiked. There actually WAS more risk (measured by volatility) in the market right when clients were (not irrationally) perceiving it. Yang suggests that advisors should acknowledge the shift in market volatility and incorporate this acknowledgement into their client communications, so that clients feel validated.
Yang’s own software helps advisors show clients the longer-term risk and return over any time horizon clients might be able to relate to. And, like the Orion 3D Risk Profiler, Andes measures risk composure—and it does it with a more precise and sophisticated instrument. Clients’ behavior is broken down into a set of factors based on the investor ‘type’ (passive, trend follower, etc.), behavioral biases and Financial IQ, each of which is independently assessed. The various assessments can be used together to cross-validate each other.
Risk capacity is often misunderstood or not implemented because the more naive outputs all seem to lead to the same conclusion. Clients with significant wealth don’t need to take high risk because they don’t need the potential excess returns. Those with few assets can’t afford to take high risk, because they can’t afford the significant consequences if the markets go down.
Yang says that the meaningful driver of risk capacity is not the amount of assets, but the client’s the investment horizon. She normalizes risk tolerance and risk capacity to the same scale, and then adds them to develop a model for what kind of portfolio an advisor should recommend. This is similar to the Kitces model, which is provided in graphic form, but then she provides her own (corrected) version of the same model illustration. (Note: Yang’s Andes program does not measure risk capacity, but she lists software that does, including Totum Wealth.)
The last chart in the article shows the four dimensions of a risk profile, and contrasts the views of Orion’s 3D risk profiler with the Kitces analysis of the topic, with her commentary, and lists the software instruments in the advisor ecosystem that address each dimension. For example, risk perception is not measured in the 3D risk profile, while Kitces says that risk perceptions shift constantly, giving the impression that risk tolerance changes. Yang’s view is that risk perception is an independent dimension, and that advisors can help clients recalibrate it. Kitces says risk composure represents the stability (or not) of risk perception. Yang and Orion believe risk composure is another independent dimension, and notes that the Andes Behavioral Risk Index is conceptually equivalent to Orion’s Risk Composure.
If you were curious about the charts taken from the Kitces musings on these risk issues, and Yang’s own version of them, an appendix shows how they were constructed—and if you missed the Kitces article on the subject, you can see his work and illustrations reproduced in this article.
The most interesting thing about this detailed analysis is that it isn’t very much more difficult to make a comprehensive assessment of a client’s risk posture than it is to produce a naive single number, and doesn’t require much more client participation in the process. This article never says this, or even implies it, but you come away realizing that the naive number is more of a marketing tool than it is a way to help put clients into comfortably appropriate portfolios.
End of Veres’ review of the article.