How do we match a person’s CART Profile with Investments?

We already know how to get a CART Profile that tells a person’s risk tolerance. Not let’s consider ways to measure risk in investments.  A Wall Street Journal May 4, 2020 article “4 Different Ways to Think about Risk”  by Suzanne McGee suggests four.  They are The Sharp Ratio, The Sortino Ratio, Downside Capture, and Morningstar risk ratings. 

The Sharpe Ratio

The Sharp Ratio developed by Nobel economics laureate William Sharpe measures the additional amount of return a fund or portfolio provides per unit of increase in risk. Here is how it is calculated.

1.  Subtract the rate of return of a risk-free asset (such as U.S. Treasury bills) from the average rate of return of a fund’s portfolio.

2.  Divide that amount by the standard deviation of the fund portfolio’s returns (i. e. the degree to which those returns vary from their mean).

So:  The ratio is largely about equating risk with volatility.

In 2007 volatility measures would have indicated that U.S. funds had never been safer on a risk-adjusted basis.  Investors who had used only this risk evaluation criteria would have “lost their shirts” in 2008.

The Sortino Ratio

Managing Director of the Pension Research Institute in Menlo Park, CA Frank Sortino’s contribution

1.  Also subtracts the rate of return of a risk-free asset from the average return of a riskier asset. 

2.  Unlike Sharpe:  It divides the resulting amount by the riskier asset’s downside deviation – or the extent to which its returns fall below what is minimally acceptable to an investor.

3.  This allows the investor to compare 2 portfolios with similar returns.  So he can see which does better at managing risk – especially when the markets are falling.

4.  So:  A higher Sortino ratio identifies a portfolio that earns more for every unit of risk that it takes.

5.  If a fund doesn’t do well at capturing the upside either it looks grim.  Why?  If your portfolio falls 40% you’ll need it to generate not 40% but 66% – just to get back to your starting point.

Downside Capture

“Downside capture” provides a variation on the Sortino ratio.

1.  It calculates a given fund’s risk-adjusted return as a function of its benchmark – such as the S&P 500 or an MSCI, or Russell index.

2.  It shows whether the fund has lost less than a broad market benchmark during periods of market weakness – and if so, how much less.

3.  How downsize-capture ratios are calculated:  Divide a fund’s monthly return by the benchmark’s return – during periods the benchmark is in the red.

4.  A score of less than 100 indicates:  A find has lost less than the benchmark during periods of market weakness. 

5.  So:  A score of less than 100 over the long haul in a variety of markets signals a manager who is doing a good job.

Portfolio Manager Steve Atkins at Polen Capital likes to work with this raw number more than either volatility measures or looking at standard deviation.  Why?   “It measures more directly how well the manager does compared to the market.”

Morningstar risk ratings

Morningstar works with other risk aspects that cannot easily be reduced to a quantitative figure.  It uses a 1 – 5 rating scale with 5 as the best.  It also indicates whether a fund is “low risk” or “below average.” 

1.  Methodology:  It emphasizes the risk that a fund will underperform its benchmark – and additionally compares how well the fund has performed in volatile or bear markets in comparison to its peers. 

2.  For example:   An “above average” rating indicates that a large-cap growth fund has done a good job of addressing risk relative to, say, the S&P 500, as well as other actively managed large-cap growth funds.

3.  Among what it does is (1) look for historical trends for funds with a longer track record and (2) assess underappreciated risks and their potential impact on returns.

This WSJ article notes that market veterans advise against emphasizing any single metric in isolation.

Eddy Vitaru, a fixed-income investor who manages the San Francisco.-based Osterweis Total Return Fund comments, “Sadly, the easiest way to learn to focus on risk is a correction.   You learn from experience rather than education.”

Can I learn from experience how to invest?

Sure.  My husband Jon and I had to stretch investments to provide college and everything else for 4 kids and our retirement.  I cut back my management consulting practice and studied investments. 

I was in the Executive Club that Scott, CFP®, was in.  He had just sold a mutual fund that he had put together.  I asked, “What are you going to do now?”  He said, “I am only going to work with people that I like.”   I waited a week and called him.

That was 35 years ago.  Of course we have made mistakes.  But Scott has taken really good care of us and our investments, and we have exceeded the goals we set.  We funded 4 kids’ lives, 5 undergraduate degrees, 1 masters, 1 Ph.D., and our retirement.

Why did I write a risk tolerance test for investors?

Scott said, “The financial industry needs a risk tolerance questionnaire that quantifies risk tolerance inherent in the investor.”  I said, “What does ‘quantify’ mean?”  He said, “Put numbers to a person’s risk. For example a person may want  50% in High Risk, 40% in Medium Risk, and 10% in Low Risk.”

In “About” you said that you enjoy learning about other professions and figuring out how psychology can work with other professions to make our lives better. What did you do to learn about financial planning?

A number of financial planners discussed their concerns about RTQs.  I asked for their input and took their advice.  They suggested books I should read, websites I should study, and professional journal articles I should review.  I did what they suggested.  I wrote the information for this website.  They reviewed it, made more suggestions, and I made revisions.  I am very grateful for their help.  To see a bibliography of 40 books, websites and professional journals I studied go here.

How does being a counselor and management consultant help you write a risk tolerance test?

I have done counseling for 30 years.   A counselor and client need to know, “What is the client’s coping strengths?”  Why?  We use these coping strengths to reach WHATEVER goal the client selects.  I did management consulting before I did counseling.  There, too we us a client’s coping strengths to reach his goals.

Does your test give percentages in Normal and Stress Conditions?

Sure.  Because we live through both. 

Did you find other risk tolerance questionnaires that give percentages in Normal Conditions and Stress Conditions?

No, but I had already used The SORT Test© in management consulting and counseling to learn a client’s coping strengths in Normal and Stress Conditions.  So I just revised it for investors.   

We could simply address another area of life – assessing the risk tolerance in a client – to see how a client uses his coping strengths there, too. 

Do investors really buy and sell because of Fear and Greed?

Some do, some don’t.  On one day an investor may want to Buy From Greed.  On another day this investor might want to Sell From Fear.  Is he in Normal Conditions?  Or Stress Conditions?  That helps a person decide.

What do financial planners and psychological professionals know about Fear and Greed?

Of course, Fear and Greed, their causes, and actions resulting from having them is not the same for everyone.  Financial planners and psychology professionals both address Fear and Greed with their clients. There is some overlap in what financial planners and psychology professionals know.

So what can we DO to grow in our understanding of risk tolerance?

A lot.  “We” can be financial planners who know investments and psychology professionals who know investors coping strengths in investors to face the task of assessing risk tolerance together.

I refer all clients to a financial planner.  Always have.  Clients need to fund their goals and dreams.

What can investors do?

Again, a lot.

1.  An investor may want to study investing.  You might invite your financial planner to be your mentor.  Ask, “What do you think I should learn?”  And then, “How would you suggest that I do that?”

2.  Whether or not you have a financial planner:  You get your Coping Strengths and Risk Tolerance (CART) Profile.  If you invest with a spouse or investment team they can get their CARTs, too. Now you can put the Average of their scores on a CART Profile Chart.

3.  If one of you likes High Risk investments more than others, that person can study High Risk investments more.  The same for Medium and Low Risk investments.

4.  Get EBooks  for all  4 CARTS ($30 total).  Use the 25 or so exercises in each one to see how to apply tools that work for each CART.  Use EBooks to teach your kids how to invest, too.

5.  You can get a list of 24 books that you can use to teach your kids and teens about investing.   Kids can learn a lot more than many people give them credit for – and can learn it earlier.  I have an 8 year old client whose father is a physician and comes to see me so that we can plan his lemonade stand business.  Who knows what business he will have next year – I am his business consultant. Many of these books and videos are very well done.  Enjoy reading them.  Play with them.  You will get a feel for which ones your child is ready for when. You and your child will have fun getting even more wisdom about money together. 

6. Doing 1. – 4. can be the best way for you and your family to take the measured appropriate risk that is best for you and your family – as you learn more about how to invest across the years.

What is our Take Away from This Website?

Let’s take Dr. John A. Lutjemeier’s conclusion with us.  “A financial planner knows how to quantify risk tolerance inherent in the panorama of investments.  The SORT Test© facilitates quantifying risk tolerance within the investor, meeting acceptable psychometric standards for validity and reliability.  With investment risk tolerance quantified and investor risk tolerance quantified, professionals can do a better job of matching the investment and the client.”

Scott, Jon, and I wish you happy and prosperous investing across the years.

On the page where you can purchase the SORT Test© you can also purchase EBooks.  At the top of the page when you open “EBooks” you will see “Kid’s Biography”.  Click it to get a list of 24 books that you can use to teach your kids and teens about investing so that they can gain wisdom about money as well as investing.  Now the child will mature as an investor across the years as s/he matures in every other area of life.  Won’t that be fun for everyone?