Overview of Andes Risk Score
Many people want to see a risk score on the scale of 0-100, because it is easy to understand. There is an easy way to arrive at such a risk scale.
Within the Andes Risk Platform, you can get a risk score ranging from 0-100 by multiplying the volatility (standard deviation) of your portfolio by 5. For instance, the volatility of a 100% equity portfolio is typically below 20, which translates to a risk score close to 100 when multiplied by five.
The risk score can be above 100 for very risk investments or during turbulent times. For example, Bitcoin's risk score can surpass 100. This article, How Risky is Bitcoin?, explains our methodology in detail.
A risk score can also be used to quantify an investor’s risk tolerance because our patented Risk Tolerance Test maps the investor’s choice directly to one of the advisor’s models.
Assigning a Risk Score to a Model
To assign a risk score to a model, we can use the model’s long-term average volatility or its capital market assumption, i.e. target return and target volatility, which is often based on its long-term average.
In the screenshot below, the 60/40 model shows a Target Return of 6.30 and a Target Volatility of 11.90, hence its risk score is 59, which is 11.90 * 5.
You may notice that the model’s risk score of 59 is very close to the percentage of equity in the model. This alignment is not a coincidence but rather a common characteristic of typical models.
Assigning a Risk Tolerance Score to Investor
Andes Risk Tolerance Test shows the upside and downside of a set of models covering the entire risk range from conservative to aggressive. When the investor chooses one, it maps directly to one of the advisor’s models. As a result, the model’s risk score is assigned to the investor as their risk tolerance score.
In the screenshot below, on the right-hand side, you can see the model the client has chosen, such as the 60/40 model. The risk score of this model, which is 59, becomes the investor’s risk tolerance score.
Portfolio Comparison
Portfolio Health Check (PHC) compares the portfolio with the target asset allocation overview. For example, the screenshot below shows that the risk score for the prospect portfolio is 97, compared to the target risk score of 59.
It is important to note that the risk of a portfolio can’t be captured by a single number, because its volatility in the short-term can be drastically different from longer-terms. When evaluating a prospect’s portfolio, a 10-year time period is often used.
Why Portfolio Risk Can’t Be Captured by a Single Risk Score?
This section illustrates how portfolio risk can look very different for short-term versus long-term, hence can’t be captured by a single risk score, but rather by a set of risk scores, each representing the risk for a certain time period.
The chart below shows the efficient frontier based on the capital market assumptions of the models. For the 60/40 model, the risk score is 59. This represents how the models are expected to behave.
The models often don’t behave as expected, especially during market turmoil. For example, For the 3-month ending 2020/03/23, you will notice a high risk score of 158. This is expected during market turmoil when risks can increase significantly.
However, if you look at the 10-year ending 2020/03/23, the risk was within expected range.
This highlights that portfolio risk cannot be accurately summarized by a single number, as short-term and long-term risks can differ significantly. During market turmoil, it's important to understand that while short-term risk may be higher than usual, the long-term path of the portfolio remains stable. Investors with a long-term investment horizon are advised to remain invested.
Conclusion
In conclusion, Andes's Risk methodology for evaluating risk through volatility offers a comprehensive and practical approach to understanding and managing risk in investment portfolios. By translating volatility into risk scores, Andes empowers advisors and clients to navigate the complexities of investment management with confidence.