What Really Matters

Frank Sortino

Sun Jul 28 2024

In this blog post, renowned financial expert Frank Sortino critiques the traditional risk tolerance questionnaire, arguing that it misrepresents risk by focusing on volatility rather than a more realistic measure of success: achieving a Desired Target Return (DTR). While Sortino refers to this concept as DTR, at Essential Returns, we use the term Essential Returns Objective (ERO). Both concepts emphasize the importance of maximizing returns above the target while minimizing risks below it.

The top photo in Figure 1 is the 1st page of a typical risk tolerance questionnaire. It asks you to describe your goal in terms of how much money you want to make. It assumes you measure risk in terms of volatility about the mean, or average return, as shown under MPT. All volatility is bad in this framework. All possible returns are contained within the blue bell shape. They ignore the Desired Target Return (DTR) you need to earn in order to replace your income at retirement. The investment objective here is to maximize the mean, subject to the amount of volatility you can tolerate. I reject this and believe it is misleading!

I assume there is some tipping point that separates good outcomes from bad outcomes, shown in blue under PMPT. T is the Target return you must earn in order to achieve some payout at a specified time in the future, like the payout your assets must provide to maintain your standard of living. All returns above T are good and the higher the better. But all returns below T are bad and the lower they are, the worse they are, because those are the returns that will keep you from achieving your goal. The potential to exceed your DTR (T) can exceed the bounds of the probability curve. Our investment objective is to maximize the potential to exceed the DTR, subject to the volatility below T. We call it the Upside Potential Ratio. We believe a picture is worth a thousand words that you don't understand. We eschew these questionnaires and do not believe they help you see the real risk-reward tradeoff to estimate your potential success or failure. Doing financial planning without calculating the DTR is like planning a trip without knowing where you are going or how to get there. Now, the title explained:

1. Who wrote the words? An attorney? Your attorney or theirs? A marketing person? A professor?
2. What was the reason? To CYA? To sell you something? To educate you, or convince you he knows something unknowable?
3. Why? To protect them from lawsuits? To inform you of ways to reach your goal? It's what they were told to believe? God only knows?
4. Where did they learn these words? Law school? An MBA program? Earning a CFA credential? A weekend course in a parking lot?
5. When did they learn this? Last year when they graduated? 50 years ago, when the world was different? When they received a certificate saying so? Never?

Good intentions are not enough! Learning should never stop! Knowing, is the impossible dream! Beliefs should be questioned constantly! All of the above could be wrong!