RiskCAT: A Framework for Identifying Maximum Risk Thresholds. in Personal Portfolios

Grable, John E.
October 2008
Journal of Financial Planning;Oct2008, Vol. 21 Issue 10, p52
Academic Journal
• This paper answers a key financial planning question: How can risk tolerance, risk capacity, and time horizon be combined to shape the development of diversified investment portfolios? A framework—RiskCAT—is presented that allows planners to determine a single risk profile score for clients. Risk profile scores indicate the maximum amount of systematic risk that is appropriate within a portfolio. • The RiskCAT framework extends the concept of multiplicative modeling as proposed by Cordell (2002). The challenge is that standardization does not yet exist within the profession to incorporate valid and reliable measures of risk tolerance, risk capacity, and time horizon. This paper offers prospective definitions for each input. • The risk tolerance input was developed from the many risk-tolerance instruments already available. A focus group of 22 experienced financial advisors created and standardized an index of risk capacity, which measures a person's financial ability to take on risk. • The investor's time horizon works as a mediating factor between risk tolerance and risk capacity. The same focus group provided a scaling system for a given investment time frame. • The multiplication of these three scores results in a beta score that measures the maximum exposure to systematic risk the client should take within the portfolio. • A value-at-risk method for validating risk profile scores is presented. The paper demonstrates that the application of RiskCAT profile scores to client situations results in a unique way to define systematic risk and place limits on risk exposures within client portfolios.


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