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User Manual & Methodology Guide
A Portfolio's Risk Score
A Portfolio's Risk Score

This article takes a deeper dive into how we assign risk scores for portfolios

Updated over a week ago

Your client has completed a risk assessment, now what? The next step would be to review their current portfolio in relation to the Risk Band.

Portfolio Risk Score

Here is an example of a client's portfolio with a risk score of 30 (note that this portfolio is within the client's Risk Band of 18-35). This means there is a 1% chance that the portfolio will lose 30% or more of its value over the next 12 months. A Risk Preference score of 18 means the client is willing to lose up to 18% in the chance of a market downturn. A Risk Capacity score of 35 means the client has the assets, income, job stability, and overall ability to recover from a 35% drawdown.

How are the Risk Scores calculated?

To calculate a Portfolio’s Risk Score, TIFIN Wealth uses forward looking returns, volatility, and correlation between the assets (using CMAs) to determine the expected return and volatility of the portfolio. Then, the portfolio's expected return & standard deviation is used to calculate the 1% VaR (Value at Risk) of the overall portfolio. Let's break this down...

Forward Looking Assumptions

Large fluctuations in interest rates and loose monetary policy can create material differences between realized (past) and expected (future) returns across various asset classes including bonds and equities. Several sophisticated investment managers have adjusted their models and believe that future returns will be lower than the returns we have witnessed over the past few decades.

TIFIN’s risk methodology utilizes forward returns for all securities based on 3 factors:

  1. Expected Asset Class Returns & Volatility – TIFIN averages Capital Market Assumptions (CMAs) reported across the largest global asset managers (i.e., JP Morgan, BlackRock, etc.) to generate a “wisdom of the experts” estimate. These fund managers have significant teams researching and developing capital market assumptions that are foundational for all investors. Assumptions are updated bi-annually when available.

  2. Exposure to Primary Asset Class – determine the variability of returns through a rolling 5- year regression between the security and its primary asset class.

  3. Value at Risk (VaR) – the portfolio is then given a score based on Value at Risk (VaR). TIFIN calculates the estimated forward Risk Score of individual securities and portfolios using a parametric VaR calculation at the 99% confidence level for a 12 month period.

In this example, the recommended portfolio has a Risk Score of 22. Net of this advisor's fees, this is showing:

  • Possible losses of -23.04%; meaning the recommended portfolio value could lose up to $15k (VaR) or more in a given year (Portfolio Value x Risk Score %)

  • Possible gains represent a potential 33.24% in upside portfolio value gains within a given year using the same distribution at a 1% chance.

Capital Market Assumptions

The chart below shows the 10-year Capital Market Assumptions (CMAs) reported across several asset manager partners. We source CMAs from over 10 of the largest global financial institutions:

  1. JP Morgan

  2. Morgan Stanley

  3. BNY Mellom

  4. Wells Fargo

  5. BlackRock

Calculating Expected Returns & Volatility

As mentioned above, TIFIN aggregates Capital Market Assumptions (CMAs) reported by the top asset management institutions and uses proprietary techniques to forecast security and portfolio-specific returns and volatility. Using Geometric Brownian Motion, TIFIN Wealth projects the Current and Recommended portfolios’ balances for 10 years.

Geometric Brownian motion (GBM) is used to describe random movements of financial assets over time where the size of the variations is proportional to the current value of the asset. GBM is the industry standard model used in finance to forecast security returns. The benefits of GBM over Monte Carlo (if you make standard industry assumptions such as normality and statis volatility) is speed (runs much faster) and will return the same results every time due to forecasting every point on the distribution versus making a random distribution. Potential drawbacks of industry standard GBM (and Monte Carlo) is the assumption of constant volatility and no drastic stock price jumps; however, over long enough time periods these potential drawbacks become mitigated.

Forward Returns Example:

  • CMAs state that the 10-year expected return of the Large Cap asset class is 10%

  • The exposure of fictitious security ABC to the Large Cap asset class is 1.2 (20% more volatile than the Large Cap asset class)

  • ABC's forward expected return = 1.2 * 10 = 12%

Calculating the Correlation Between Each Holding in the Portfolio

Does the portfolio risk score consider the correlation between the holdings within the portfolio? Yes!

Once we've calculated each individual security's expected return and volatility, we also calculate the forward pairwise covariance matrix (another way to think about this is the correlation) between each security in the portfolio. We then use each security's weight, each security's expected volatility, and the pairwise covariance (correlations) between each holding in the portfolio to calculate the portfolio's standard deviation.

For reference here is a screenshot of the formula to calculate portfolio standard deviation, which includes the covariance mentioned above:

This is for a 2 asset portfolio:

For a three asset portfolio:

We then calculate the portfolio's expected return which is a simple weighted average. Next we use the portfolio's expected return and the portfolio standard deviation to calculate the 1% VaR of the portfolio.

Potential Forward Returns

When looking at the 5-Year Potential Returns Forecast chart in the IPS, TIFIN forecasts the 85th percentile and the 15th percentile of expected returns. This implies that 15% of expected returns are above the 85th percentile or "Upper" band and 15% of returns fall below the 15th percentile or "Lower" band. In other words, ~70% of the time portfolio balances will fall in between the “Upper” and “Lower” bands (shaded area) given the forecasted portfolio’s return and volatility.

  • The “Mean Band” represents the expected return (50th percentile) of the respected portfolio (Current or Recommended) over the next 5 years. Generally speaking:

    • ~50% of the time the portfolio returns will be above the Mean Band.

    • ~50% of the time the portfolio returns will be below the Mean Band.

  • The “Lower Band” represents the bottom 15 th percentile of possible portfolio balances. Generally speaking:

    • ~85% of the time the portfolio returns will be above the Lower Band.

    • ~15% of the time the portfolio returns will be below the Lower Band.

  • The “Upper Band” represents the top 85th percentile of possible portfolio balances. Generally speaking:

    • ~85% of the time the portfolio returns will be below the Upper Band.

    • ~15% of the time the portfolio returns will be above the Upper Band.

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