Risk Capacity Portfolio Construction

Abstract

This paper introduces a portfolio construction framework for risk-averse investors that aim to meet or exceed a client’s capital accumulation needs for a future event, such as retirement. Risk Capacity Portfolio Construction (RCPC) presents a risk-optimized alternative to Target Date Funds (TDFs). Risk Capacity Portfolio Construction is an economic sciences innovation that is validated by Skew-Risk Modeling, which was first presented in Targeted Return Portfolio Construction (Sherwood, 2019) and is detailed within this paper in its application to retirement-focused investors. Risk Capacity Portfolio Construction factors skewness and kurtosis into the risk management and asset allocation of an individual’s life cycle and can optimize risk beyond simply accounting for the equity risk premium and human capital.

TOPICS: Portfolio construction, portfolio theory, wealth management, retirement, tail risks, equity portfolio management, options

Key Findings

• ▪ This paper highlights an alternative portfolio construction methodology to Target Date Funds (TDFs) in order to better prepare individuals for retirement, on both a risk-adjusted and absolute basis.

• ▪ This paper highlights an investor’s ability to incorporate skewness and kurtosis within the asset allocation process of a portfolio that is intended to prepare an individual or group for a future dated event.

• ▪ This paper highlights how the implied risk probabilities within the options market, referred to herein as Tail Risk Ratios (TRR), can be incorporated in the investment process.