A New Way to Calculate Risk Tolerance
For decades investment advisors assessed risk tolerance by fleshing out clients’ feelings about investment loss: “Could you sleep at night knowing you might experience a 10-15% drop in your portfolio in any given year?” for instance.
But Tolerisk, a new data-driven risk tolerance tool, aims to provide a more scientific approach, taking into consideration a clients’ actual financial ability to withstand risk. “We’re the only (program) using cash flow in risk tolerance assessment,” explains Tolerisk creator Mark Friedenthal.
Friedenthal started with just an Excel spreadsheet in 2009 and eventually hired his own software programmers to create the cloud-based Tolerisk. His goal was to analyze clients’ anticipated cash flows in and out over time and calculate the correct percentage of stocks vs. bonds they should have in their portfolios. He came out with a beta version of Tolerisk in 2014 and launched formally last year.
“We gave it to small number of advisors around country, and worked with them to improve the product over the next year and a half, to improve functions, and make it something advisors wanted,” he says.
Tolerisk includes a series of questions on personal comfort with investment risk, as well as asking for information about current and future cash flows. It combines an investor’s willingness to take risk, with their financial ability, in a dynamic way.
For instance, if a client, through the Tolerisk questionnaire, shows a high ability to take risk due to their higher level of cash flows (or the fact they’re not using the money for a long time), then their personality (and comfort with risk) would count more towards the calculation.
Contrarily, if an investor had a reduced ability to withstand risk, regardless of their age (if they had capital expenditures on the horizon such as putting kids through college and so forth), then their personality counts for less in the score.
Instead of putting people into nebulous “aggressive, moderate, or conservative” categories, Tolerisk produces a precise “risk directive” number called the Tolerisk Score.
For instance, a Tolerisk Score score of 76, would indicate the client should be in 76% stocks.
Tolerisk has been getting attention in the financial media, including in Michael Kitces’ Nerd’s Eye View blog. A Tolerisk subscription is available to solo advisors for $59/month, and special pricing is available through several firms.
A New Take on Mortality
In addition to cash flows, Tolerisk offers a new spin on mortality probability that also promises more precision. “Financial planning tools usually select a date in time, say, age 95, which is meant to be a stressed lifespan, then they run a simulation to see if an investor will outlive their money.”
Tolerisk takes that a step further, Friedenthal says. “We’ve built in the IRS’ unisex mortality data. We know for someone of every age, whether they’re 3, 47, or 92, what percentage of their cohorts survived the next year. What we have, for anyone of any age, is a curve of probabilities of death, for each year from the current year to 120.”
Using different life expectancies, Tolerisk can produce an average for a 50-year-old that might be 83. But an individual client might have good heredity, good exercise, sleep and nutritional habits, that would extend their life expectancy to 93. Friedenthal says: “We take data from the tools, and adjust mortality. And we let you do it for both spouses independently.”
This allows advisors to calculate second-to-die probabilities, and layer on cash flows, equity returns, and inflation. “We’re able to boil all that down to a single probability of you or your spouse running out of money,” Friedenthal says.
“Clients want to know the right level of risk to be taking now as well as the probability they will run out of money,” he adds. “If a client has a 45% probability of outliving their money, they may want to think about working longer, saving more, or selling their vacation home if they want to retire as desired. Advisors don’t want to provide advice on something as important as a risk directive based on an unrealistic set of assumption. Advisors can work with their client to ascertain the most palatable choices in concert with providing the right advice on a risk directive.”
Quick and Easy
Tolerisk offers a quick 30-question assessment of personality and cash flows – but also offers an abbreviated six-question five-minute test for prospects that advisors can embed on their websites.
“It gives prospects something useful while they’re deciding if this is someone they want to work with,” he says.
Friedenthal says Tolerisk compliments Naviplan, e-money, and other more robust financial planning programs.
“Our risk tolerance assessment is a much shorter exercise than a comprehensive financial plan,” Friedenthal says. “It fills in part of the gap and clients can do Tolerisk first before comprehensive planning.”
By sequencing near-term and long-term capital expenditures, Tolerisk can help clients develop a risk tolerance assessment based on sound assumptions, he says.