Since Harry Markowitz developed the center variance optimization of contemporary portfolio theory (MVO), financial advisors and asset managers were confronted with a vital query: What is the relative importance of risk tolerance (the attitude of the investor to risk) in comparison with the chance capability (the flexibility of the investor, negative outcomes)?
I actually have to confess that I actually have been at a lack of this query for a long time. My frequent co-author Paul Kaplan, and I believe we’ve got solved this puzzle with an prolonged MVO optimization model called Net Worth Optimization (NWO).
How did we get here?
The goal (objective function) of the mean variance optimization is to maximise the expected return of a portfolio minus A for the expected risk (variance) of the portfolio. If the investor’s risk tolerance coefficient is multiplied by the variance of the portfolio.
In MVO, the coefficient “risk tolerance” is a single number that reflects the speed with which the investor is willing to satisfy more risk of more return. With the knowledge of the investor’s risk tolerance coefficient, you may solve for the corresponding MVO -efficient portfolio.
In the economic literature and the works of Nobel Prize winners resembling Paul Samuelson, the chance tolerance is clearly related to the chance and never risk capability.
Consultants often have a deep understanding of their customers’ situations. This can include information on additional accounts, spouse’s assets, remuneration information, mortgage payments, etc. While other customers feel extremely uncomfortable with risks, but can tolerate disadvantageous results, whereby there are only minor effects on their financial well -being. Consultants navigate from highly subjective risk tolerance (setting) in comparison with the chance capability puzzle.
Two approaches to risk capability
There were two approaches pragmatically that expressly give attention to risk capability.
The first approach is a typical feature of the “evaluation component” of questionnaires of risk tolerance. When evaluating the answers to a questionnaire on risk tolerance, there are sometimes two points: a risk tolerance assessment and a time horizon value. The Time Horizon Score serves as a rough deputy for the flexibility of the investor to take risks which are taken for suitable portfolios.
The second approach might be less known to practitioners, but is widespread in practical-oriented literature. This approach is best represented by the “discretionary asset hypothesis”, which is especially presented by Jarrod Willcox.[1] In a lot of these approaches, the attitude of the investor to the chance is reduced or ignored, and financial circumstances resembling the ratio of assets to the lines are used because the primary factor to estimate a so -called “risk tolerance coefficient).
Net assets optimization (NWO)
The economic balance sheet of an investor includes all of its assets – house, country, collector’s items and all financial assets. The most vital thing is that the economic balance sheet includes the capitalized value of the lifespan of the investor’s income – human capital. For many individuals, the mortality rate of weighted net value of all future work revenue, including a postponed income in the shape of defined benefits and social security, is its best capital.
The lifespan of money flows that arise from the human capital often remind you of the money flows, which you’d receive from a big, inflation -bound long -term bond. Others have less regular human capital that resembles a stock/bond mix.
On the appropriate side of an economic balance, we’ve got all ongoing expenses resembling rent, mortgage, insurance, medical costs and food. Although it will not be legal liabilities, these costs are sometimes inevitable. Overall, their activated values ​​form what we regard as non -discretionary consumption liability of the investor.
Just as a balance is a vital indicator of the financial health of an organization, a holistic individual economic balance is a superb indicator of the final financial health and capability of the investor to take risks. The difference between the whole value of all assets and all liabilities is net assets. Hence the term assets optimization or NWO.
NWO comprises all essential economic records. Non -charging entries – the human capital of the investor and the non -discretionary consumption liability – are included within the optimization, although the optimizer cannot change the online value of each. These non -traditional assets are modeled as portfolios of asset classes, with which we are able to properly derive market -based discount rates and understand how you can interact with the remainder of the balance sheet.
Imagine a 45-year-old pharmaceutical scientist with a basic salary of $ 200,000, which is customized to inflation yearly and receives the nominal stock units of $ 100,000 with a five-year exercise plan, which also receives around $ 25,000 per 12 months from the age of 65.RDS Long -term inflation -adjusted corporate bonds with a duration that corresponds to the 20 years of money flows, and almost 1/3RD Mid cap shares (reflect the scale of the corporate).
You could refine the 1/3RD Mid cap shares by modeling them based on the pharmaceutical sector and even using the respective stocks. The current net value of social security is just not a lot price today, but also needs to be taken under consideration properly. The expected returns of every type of the premise for a weighted average capital costs to calculate the worth of the scientist’s human capital.
The capitalized value of the non-discretionary consumption liability of the investor, which is analogous, as a long-inflation-bound bond with outgoing voucher payments issues, is contained as a non-tradable negative participation within the optimization.
Then, within the presence of non -powerful assets and liabilities, the optimal project of assets for the tradable assets of the investor – an optimization that fully accounts for the flexibility of the investor to take the chance.
Life through life happens. The customer might be fired, the worth of the stocks rose, inflation could increase/reduce, found a family or a non -insured house on the coast, etc. critically, because the value of the person’s assets further develops in comparison with the worth of the liabilities, the financial health and the flexibility of the person to enter into the chance evaluation. In contrast to MVO, only from Asset does NWO record the flexibility of the investor to take the chance.
In an article in February 2025 “,”Net assets optimization“Kaplan and I discuss greater than 8,000 net assets wherein we varied the human capital of the investor and the composition of the investor’s economic balance. As Figure 1 shows, after the chance tolerance of the investor has been controlled, the quantity of the equity for business assets of the investor is of the investor’s equity.
Figure 1: Optimal finance capital.
Source: Veakk and Kapron (2025).
In Figure 1, each point is the common equity of economic capital from 180 optimizations that correspond to different combos of human capital and risk tolerance. Since the holistic economic balance is reinforced, it is perfect to take more risk.
Ridden solved
There is not any riddle with NWO. We now not must ask what’s more essential to take the client’s hiring to the chance or the flexibility of the client to take risks.
With NWO you should use the client’s risk tolerance in addition to intended – to reflect the client’s hiring towards the chance. The most vital thing is that NWO also goes far beyond the time horizon deputy of the chance capability by completely reflecting the flexibility of the client to take the chance of being recorded by a holistic and developing economic balance.
With the further development of net assets optimization, the financial planning industry from MVO should pass to NWO.
References
Idzorek, Thomas M. and Paul D. Kaplan. 2025. Net capability optimization. “8 (1): E1200. https://onlinelibrary.wiley.com/doi/epdf/10.1002/cfp2.1200
Straehl, Philip U., Robert Ten Brincke and Carlos Gutierrez Mangas. 2024. “Should your stock portfolio take your career into account?” Morningstar Research Paper, June 21.
Wilcox, Jarrod W. 2003. “Harry Markowitz and the discretionary asset hypothesis.” 29 (3): 58 – 65. DOI: 10.3905/JPM.2003.319884
Wilcox, Jarrod W. and Frank J. Fabozzi. 2009. “A discretionary asset approach for investment policy.” 36 (1): 46-59. DOI: 10.3905/JPM.2009.36.1.046
[1] Examples are Wilcox (2003), Wilcox, Horvitz and Di Bartolomeo (2006) in addition to Wilcox and Fabozzi (2009).
