Key concepts in risk profiling and scoring

Following from what we established in Chapter 2, What Makes Up a Robo-Advisor?, the fundamental basis of Robo-advisors is Markowitz’s Modern Portfolio Theory (MPT). This isn’t to say that it is impossible to avoid MPT, but that in most countries, the regulations set by the government for oversight of financial services dictate the usage of at least certain aspects and assumptions of MPT.

One of those assumptions is that investors should only take more risk in return for more rewards or higher returns. This means we need a way to gauge how much variance and volatility the investors are willing to endure in order to achieve a desired investment return. One such approach would be simply asking that exact question in numerical terms, but in reality, that isn’t viable for most investors to answer rationally. Therefore, the industry practice has defined proxies for risk in the form of risk tolerance and risk capacity. These...