Table of Contents
Since Harry Markvitz developed the Pisces-Verion Optimization (MVO) of the modern portfolio theory, financial advisors and money managers have been faced with an important question: Risk capacity (the attitude of investor’s risk) Risk capacity (the ability to tolerate negative results) What is the relative importance of the investor’s relative importance?
I should accept that I have been surprised by this question for decades. My frequent co-author, Paul Kalan, and I believe that we have solved this 50+ year coincidence, which is an extended MVO adaptation model called Net Worth Worth Optimization (NWO).
I plan to discuss our conclusions on my panel at CFA Institute Live 2025 in Chicago in May.
How did we get here?
The goal of mean-verse optimization (objective function) is to maximize the expected return of a portfolio, minus A Personal punishment For the expected risk (variance) of the portfolio. Personal punishment The investor’s risk tolerance coefficient is multiplied by the variance of the portfolio.
In MVO, the “Risk Tolerance” coefficient is a single number that shows the rate on which the investor is ready to trade higher risk in search of more expected return. Knowing the risk tolerance coefficient of the investor allows you to solve it for this MVO skilled portfolio.
In the functions of the Nobel Prize winners such as The Economics Literature and Paul Samuleson, the risk tolerance clearly relates to the attitude of the investor, not the risk capacity.
Advisors often have a deep understanding of their customers’ conditions. This may include additional accounts, spusal assets, compensation information, information about mortgage payment etc. Some customers can be very comfortable with risk, but with great ability to adverse consequences given their circumstances. While other customers are extremely uncomfortable with risk, their financial welfare may bear adverse results with little impact. Advisors find themselves navigating themselves as to what is a highly subjective risk tolerance (attitude) versus risk capacity.
Two approaches for risk capacity
Practically, there are two approaches that clearly focus on risk capacity.
The first approach is a common feature of the “scoring” component of the Risk tolerance questionnaire. When scoring reactions to a risk tolerance questionnaire, there are often two scores: a risk tolerance score and a time horizon score. The time horizon score acts as a raw proxy for the capacity of the investor, which is to take the risk to limit parts that are considered to be suitable for portfolio.
The second approach is probably less known to doctors but is prevalent in businessman-oriented literature. This approach is mainly presented by the Jarod Wilcox by “discretionary money hypothesis”.[1] In this type of approaches, the attitude of the investor towards the risk is exempted or ignored, and the financial ratio like the ratio of property-to-attackers is used as a primary factor to estimate a so-called “risk tolerance coefficient.
Net Worth Optimization (NWO)
In our 2024 CFA Institute Research Foundation Book, “Lifetime Financial Advice,” Couple and I put NWO ahead. This is an important expansion of MVO. The NWO involves all the property and laboratories of the investor in adaptation, especially human capital, and it optimizes the overall economic balance sheet of the investor.
An investor’s economic balance sheet consists of all its assets – home, land, collectable and all financial property. Most importantly, the economic balance sheet includes the lifetime of the investor’s lifetime – the capitalized value of human capital. For many people, mortality weighs the net current value of all future labor income, including defined benefits and social security postponed labor income, their greatest assets.
The lifespan of cash flows arising from human capital often reminds of the cash flow you will receive from a large, inflation, long -term bonds. Others have less stable human capital that may be similar to stock/bond mix.
On the right side of an economic balance sheet, we all have expenses, such as rent, a mortgage, insurance, medical cost and food. Although these may not be legal liabilities, these expenses are often indispensable. Collectively, the creation of their capitalized values. We think as the investor’s nondiscretionary consumption liability.
The way a balance sheet is an important indicator of financial health of a corporation, an overall individual economic balance sheet is an excellent indicator of the investor’s overall financial health and ability to take the risk. The difference between all assets and the total value of all liabilities is net value. Hence the word net vessel optimization or NWO word.
The NWO includes all major economic balance sheets entries. Nontradable Entries – Investor’s human capital and nondiscretionary consumption liability – optimization, although the optimizer cannot either change the net current value. These nontradadeable assets are designed as portfolio of asset classes, which enable us to achieve proper market-based discount rates and understand how they interact with the remaining balance sheet.
Imagine a 45 -year -old drug scientist with a base salary of $ 200,000, adjusted each year for inflation, receiving $ 100,000 nominal banned stock units with a five -year vested program, which expects to get approximately $ 25,000 per year from social security starting at the age of 65.RDS Long-term corporate bonds with a period corresponding to 20 years of cash flow, and approximately 1/3Third Mid-cap stock (reflecting the size of the company).
You can refine 1/3Third Mid-cap stocks by modeling them at the base of the pharmaceutical field or even using specific stock in question. The current pure current value of social security is not as worth today, but it should also be properly responsible. Each form is the basis for the weighted average cost of capital to calculate the value of human capital of the expected scientist.
The capitalized value of the investor’s nondiscretionary consumption liability, which is somewhat like releasing a long-term-torrent bond for a longer period with outgoing coupon payments, contains a nontradable negative holding in adaptation.
Then in the presence of nontradable assets and liabilities, NWO determines the optimal asset allocation for investor’s traditional assets – a adaptation that is fully responsible for the ability of the investor to take the risk.
One has to move through time. The customer can be removed, the value of the stock can go up/below, can increase/decrease inflation, start a family, or wash an unintended house on the coast, etc., etc., etc., seriously, develops the value of a person’s property relative to the value of liabilities, the ability to develop financial health and risk of the person. Unlike asset-only MVO, NWO perfectly captures the investor’s ability to take the risk.
1 February 2025 Financial plan review Articles, “Net Worth Worth Optimization,” couples and I discuss more than 8,000 net worth optimization in which we differ in the structure of the investor’s human capital and investor’s economic balance sheet. As Figure 1 shows, after controlling the risk tolerance of the investor, the amount of equity exposure increased for traditional financial assets with the relative strength of the investor’s economic balance sheet. We believe that this is a new, but easy result.
Figure 1: Optimal Financial Capital Equity Level.
Source: Weekk and Caperron (2025).
In Figure 1, each dot is an average equity level of financial capital from 180 net vertical optimization to correspond to various combinations of human capital and risk tolerance. As the overall economic balance sheet is strong, all the rest is optimal to take more risk.
Solved
There is no puzzle with NWO. We no longer need to ask who is more important, the customer’s ability to take the customer’s attitude or risk to the risk.
NWO allows you to use the customer’s risk tolerance because it was intended – to reflect the customer’s approach to the risk. The most important thing is that NWO simultaneously becomes beyond the time of the risk capacity by completely reflecting the customer’s capacity to take the risk occupied by an overall and developed economic balance sheet.
With the advancement of net worth optimization, the financial planning industry should move from MVO to NWO.
Reference
Thosreke, Thomas M., and Paul D. Coupon. 2024. Life Financial Advice: A personal optimal multi-level approachCharlotsville, VA: Research Foundation of CFA Institute. https://rpc.cfainstute.org/sites/default/files/files/files/files/-dia/dochants/article/rf- breif/lifetime-financial-dvice.pdf
Thosreke, Thomas M., and Paul D. Coupon. 2025. ,Net vertht optimization. , Financial plan review 8 (1): E1200. https://onlinelibrary.wiley.com/doi/epdf/10.1002/cfp2.1200
Straihal, Philip U., Robert Ten Brink, and Carlos Gutrez Mangas. 2024. “Should your stock portfolio consider your career?” Morningstar Research paper, 21 June.
Wilcox, Jerode W. 2003. “Harry Markvitz and discretionary money hypothesis.” Portfolio management journal 29 (3): 58 – 65. Doi: 10.3905/jpm.2003.319884
Wilcox, Jerod W., and Frank J. Fiboji. 2009. “A discretionary money approach to investment policy.” Portfolio management journal 36 (1): 46-59. Doi: 10,3905/jpm.2009.36.1.046
Wilcox, Jarod W., Jeffrey E. Horvitz, and Dan Dackartolomo. 2006. Investment management for taxable private investorsCharlotsville, VA: Research Foundation of CFA Institute.
[1] Examples include Wilcox (2003), Wilcox, Horvitz and Di Bartolomo (2006), and Wilcox and Fiboji (2009).
