How to Derive a Risk Score of 0-100?

Helen Yang, CFA, February 18, 2022, Advisor Perspectives

It is intellectually and emotionally satisfying to map something to a scale of 0-100, and investment risk is no exception. Riskalyze (now Nitrogen), Morningstar and Orion, among others, have all adopted a risk scale of 0-100. 

How can you derive such a risk scale? This article shows that it can be readily achieved by multiplying the volatility by five, in which case the risk score of cash is 0, equity close to 100, TSLA (Tesla) 300, and bitcoin 400. 

Why multiply volatility by five? Since the average volatility of SPY (S&P 500) is close to 20, and it would be reasonable for SPY, which is 100% equity, to have a risk score close to 100; a simple mapping would be to multiply the volatility by five.

Let’s find out if this simple algorithm matches our intuition, using Morningstar Risk Ecosystem as an example.

Morningstar’s Risk Ecosystem adopts a scoring scheme from 0 to 100 for investor risk tolerance and investment risk. This chart shows an investor with a risk tolerance of 52, and the risk scores for common portfolios. Note how the risk scores for conservative, moderate and aggressive are aligned with our common notion.

Let’s find out if this set of risk scores matches our simple algorithm above. The table below lists the volatility of common asset allocations with SPY and BND (Vanguard Total Bond Index). For example, the 20/80 portfolio has 20% SPY and 80% BND.

Comparing this to Morningstar’s risk scores, it suggests that Morningstar’s conservative portfolio is a classic 20/80 portfolio, moderate conservative 40/60, moderate 60/40, moderate aggressive 80/20, and aggressive, close to 100/0. 

This is consistent with our common understanding, which validates my hypothesis that the risk score can be simply derived by multiplying volatility by five.

What is the risk score of bitcoin? As of 2/10/22, the annualized 5-year return of bitcoin was 112.5%, and the annualized volatility was close to 80. Using the simple algorithm above, we can conclude that the risk score for bitcoin is 400.

As a point of reference, the volatility of SPY was 92 for the one-month period ending 3/30/22 and 94 for the one month ending 10/08/08. If you invest in bitcoin, you are living in financial crises every day. 

But comparing bitcoin to S&P 500 is not fair. A single security should be riskier than S&P 500. How does bitcoin compare to TSLA (Tesla), one of the riskier stocks? If we apply the same definition, the risk score for TSLA is 300.

Bitcoin is riskier than TSLA, but not otherworldly.

What advice should financial advisors give to their clients about bitcoin? If clients can invest in TSLA, why not bitcoin?

The biggest problem that I have with bitcoin is its lack of fundamentals. You can drive a Tesla, but bitcoin delivers zero real value. The original article discusses the bitcoin mining process in detail to demonstrate this point.

This is not to say that people can’t have some fun with bitcoin as pure speculation. If the client is so inclined, it is fine to allocate a small percentage of their assets to a sandbox, where they can invest (play) in bitcoins, options, or anything they fancy, knowing that they could lose everything in the sandbox without jeopardizing their financial goals. 

But if clients come to your office with a risk tolerance score in the 50s or even the 70s, you might make them aware that their bitcoin holdings are going to expose them to portfolio risks a few standard deviations off the far end of the spectrum.  

In conclusion, Helen Yang’s analysis reveals that Bitcoin, with a risk score of 400, is significantly riskier than Tesla (TSLA), which has a risk score of 300, when using a volatility-based risk scale. However, the difference in trading days between Bitcoin and Tesla partially accounts for this disparity. Despite Bitcoin’s higher risk, its risk profile is not vastly different from other high-risk assets like TSLA. Financial advisors should consider these findings when advising clients, especially in the context of their overall risk tolerance and investment goals. Bitcoin’s high volatility makes it suitable for a small, speculative portion of a portfolio rather than a core holding. Understanding the mechanics and inherent risks of Bitcoin mining, as well as the finite supply of Bitcoin, can help investors make more informed decisions. While Bitcoin can offer high returns, it also demands a high tolerance for risk and volatility.

Helen Yang, CFA, is the founder and CEO of Andes Risk, a Lexington, MA-based provider of technology solutions for financial advisors.

This article was originally published by Advisor Perspectives.