Smarter Solutions

Risks are paramount and ever present in investing. In good times, risks recede into the background, they draw little attention and seem non-existent. That’s why when market conditions turn negative, usually without much warning, fear takes over, triggers unplanned action even by experienced investment professionals; and losses are magnified undermining investors’ long-term investment goals and possibly their long-cherished life styles.

In investment, Modern Portfolio Theory (“MPT”) created in 1952 by the Nobel Laureate Harry M. Markowitz has dominated the thinking and practice of making investment decisions, to this very day.

Briefly, MPT stipulates that investment decisions depend on two variables: risk and return –and only these two variables. To construct portfolios of risky securities, the measurement of “risk” is all-important ––to correctly calculate the risks of the portfolios, to determine whether the potential return of each portfolio is commensurate with its risk, and importantly, whether the recommended portfolio’s risk is suitable for a specific investor.

A quantitative process called Mean-Variance Optimization (“MVO”) is the application of MPT for formulation and construction of investment portfolios. In MVO, volatility (or standard deviation, i.e., the square root of variance of return) is specified as the risk measure.

Over the last two decades or so, MPT experts and behavioral economists have proven that volatility as the measure of risks specified in MPT is inadequate.

This has serious consequences for clients of advisers who use MVO for giving investment advice, or traditional characterizations like “conservative” or “aggressive”. As stated by a risk expert,

As stated by a risk expert, “The problem with robo-advisors is that they don’t properly calculate a client’s risk tolerance. And without a scientifically accurate risk-tolerance process, robo-advisors are at risk of recommending investments that are not suitable for their clients.” ( Think Advisor, February 17, 2016)

In fact, the “Report on Digital Investment Advice” by FINRA noted wildly different advices provided by robo-advisers to investors with similar risk profiles.

Recent discoveries in finance theory and behavioral economics have brought new and real-world understandings of risk attitudes and more realistic measures of investment risks. In particular, they have found that, in reality, investors are particularly concerned about risks of capital losses, more so than the up and down movements of the markets. Furthermore, the Prospect Theory created by the 2002 Nobel Laureate in Economics Daniel Kahneman and Amos Tversky posits that investors feel greater pain from a loss than satisfaction from gains of the same amount. Behavioral factors have also been found to frame and shape investor attitudes toward risks.

Managing the risks of your investments is paramount to KYUR.

Applying these innovations, from advanced MPT and behavioral finance, KYUR has developed the PMO (Post Mean-variance Optimizations) discipline and quantitative algorithms to drive investment selection and portfolio construction.

In PMO, “risk” is the risk of capital losses, that is, the probabilities and amounts of losses, plus factors particular to individual investor personal circumstances and needs. KYUR converts the resulting PMO risk scores into “Risk Temperatures” specific to different investors, for easy reference.

Please read more here for a detailed analysis of PMO.

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