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Each person has a unique Risk Capacity™. The question is, how do we measure this capacity and find the right "bull" for you to ride? "Holding risk" is like riding the bull, and the returns are the greatest for those with the highest capacity for staying on the bull market through the ups and downs. Now that we have investigated the pitfalls of active investors, learned the language of Riskese™, and reviewed the history of various indexes, we are ready to move into the implementation phase of the 12-Step Program. This next process is what we call CEO Investing. CEO stands for capacity-exposure optimization and is the process that best matches people with portfolios. At the intersection of Risk Capacity™ and risk exposure sits a portfolio that will be optimal for each investor, and will therefore generate optimal returns (see Figure 10-1). Each investor is entitled to a level of return that is commensurate with his Risk Capacity™. Based on this logic, the measurement of Risk Capacity™ can be elevated to a very high level of importance and can now be addressed as the first step in the implementation phase. The reason investors only earn approximately five percent of market rate of returns is that their risk exposure is constantly moving from high to low. For example, if an investor has a Risk Capacity™ of 65% and selects a risk exposure of 35%, he is being overly conservative. When stock market returns start taking off, this investor feels he should further increase his risk exposure. What often occurs is he then moves his exposure up to 95%. At a higher exposure of 95%, the portfolio is required to have high volatility, which eventually scares the investor back down to a 35% exposure. The optimal scenario for this investor is to choose a 65% exposure to match his 65% Risk Capacity™ and ride it. The market is like a wild bull trying to buck investors off its back. The objective of CEO investing is to find the bull each investor can stick with and ride until the buzzer sounds. In this analogy, the buzzer represents an investor’s need to withdraw funds from his account. There are five dimensions of Risk Capacity™. Each one can be carefully measured with a properly designed survey consisting of 25 questions, along with an expert in CEO investing. This thorough analysis is critical to pinpointing the optimal portfolio of index funds, which will provide the optimal returns for each investor. The five dimensions for determining Risk Capacity™ are discussed in this step. Since all of long-term returns are determined by asset allocation or risk exposure, it is essential that each investor thoroughly understand the individual components of Risk Capacity™.
Mark Hebner explains the five dimensions of Risk Capacity in this video.
The dimensions of Risk Capacity can be broken down into five categories defined as follows.
The Time Horizon and Liquidity Needs dimension estimates how rapidly investors may need to withdraw money from their investments. A low score indicates that an investor may need money in less than two years. A higher score indicates that an investor may not need to withdraw money for ten years or more. The longer an investor holds onto a risky asset with at least a twenty year record of associated returns, the less chance there is of obtaining a poor cumulative return. The time series graph will show you the importance of time horizon and how it relates to risk and return. Select different time periods and see how it affects the distribution of returns.
The Net Worth dimension estimates capacity to take various levels of risk with investments. A high net worth provides a cushion for the uncertainty of future cash needs. Because life is a random walk, we are never certain of tomorrow’s requirements. The more assets there are in reserve, the higher one’s capacity is for risk. The higher the net worth, the higher the capacity for risk. See the net worth calculator below.
Your net worth is the value of all of your assets, minus the total of all of your liabilities. Put another way, it is what you own minus what you owe. If you owe more than you own, you have a negative net worth. If you own more than you owe you will have a positive net worth. This calculator helps you determine your net worth. It also estimates how your net worth could grow (or shrink!) over the next ten years.
Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.
Managing your monthly budget can be difficult and frustrating. One of the most important aspects of controlling your budget is to determine where your money is going. This calculator helps you do just that. By entering your income and monthly expenditures, you can see how much you have left to save and where your money is being spent. In addition, you can click the "View Report" button to compare your budget breakdown to our targets, which can help identify areas for improvement.
Your investment returns are 100% explained by Risk Capacity™, because your capacity directs you to your proper risk exposure, also referred to as your asset allocation or investment policy. The result of a careful analysis of your Risk Capacity™ is a risk exposure that you can hold on to through thick and thin, or the ups and downs of the market. This minimizes transaction costs and optimizes long-term returns. When your Risk Capacity™ and your Risk Exposure are aligned, your returns are optimized.
The problem many investors face is the improper measurement of their Risk Capacity™. Each dimension has to be carefully examined and then quantified. Finally, some dimensions are more important than others, so they must carry more weight in the determination of a final score. As in any survey, the questions must be carefully designed, and the investor must be totally honest and accurate.
The second problem investors face is that their Risk Capacity™ changes with time and circumstances, and they fail to recalibrate their capacity on an annual basis. Just as a portfolio needs rebalancing to maintain consistent risk exposure, the dimensions of Risk Capacity™ need to be remeasured to maintain a consistent Risk Capacity™ that matches the changing circumstances.
The five dimensions of Risk Capacity™ are measured through a Risk Capacity™ survey that poses several questions to the investor. This survey is the single most important step of the investment planning process. Index Funds Advisors offers three surveys on their website at www.ifa.com. The complete survey includes twenty five questions, the 401(k) survey has nineteen questions, and the quick survey is comprised of five questions. Based on the answers from the two longer surveys, a thorough analysis is generated. The quick survey is designed to provide an overview of the five dimensions and should not be relied on for determining asset allocation, unless the answers are discussed with an investment advisor. The quick survey asks the following five questions:
1. Assume your investments do not increase in value. Within how many years do you plan to withdraw more than 20% of all your investments?
a. less than 2 years b. more than 2 but less than 5 years c. more than 5 but less than 10 years d. more than 10 but less than 15 years e. more than 15 years
2. What is the current value of your long-term investments? Please include your retirement savings plan with your employer and your individual retirement accounts (IRAs.)
a. Less than $50,000 b. $50,000 to $100,000 c. $100,000 to $150,000 d. $150,000 to $250,000 e. $250,000 or more
3. What is your total annual income after the deduction of taxes?
a. Less than $50,000 b. $50,000 to $75,000 c. $75,000 to $99,999 d. $100,000 to $199,999 e. $200,000 or more
4. What is the worst twelve month unrealized percentage loss you would tolerate for your long-term investments?
a. -50% b. -40% c. -30% d. -20% e. -10%
5. How would you rate your knowledge about investing in general and more specifically, the relationship between risk, return, and time?
a. significantly below average b. below average c. average d. above average e. expert
The total score of a survey is the sum of the scores in each category, each weighted by its estimated contribution to overall capacity. Higher scores point toward higher risk, higher returns, higher volatility, lower-liquidity, and longer-term investments. These would include a larger allocation of Small Capitalization, Value, International and Emerging Market Indexes. A weighted total score of 100 indicates the highest capacity for risk. On the other hand, lower scores would match up to portfolios with lower risk, lower returns, lower volatility and higher liquidity. These would include shorter-term investments such as fixed-income. Take the Risk Capacity Survey here.
The investment meter is a device that shows the scores of the five dimensions as percentages of the maximum possible for each category. It is another way to look at Risk Capacity™ and the resulting risk exposure. Each category is assigned a numerical weight according to its estimated contribution to Risk Capacity™, and a weighted total score is then derived. The bar chart below shows your results in each category, and your overall Risk Capacity™. Each category result is shown as a percentage of the maximum possible for that category. Then each category is assigned a numerical weight according to its estimated contribution to your capacity for risk and added for the weighted total score, also shown as a percentage of the maximum possible. A weighted total score of 100 indicates the highest capacity for risk.
The 10 dimensions of risk are shown in Figure 10-5 and the method of measuring and weighting the categories are depicted in the investment meters in Figures 10-6 and 10-7. In Figure 10-6, an individual’s five dimensions of capacity are shown with a meter depicting the scores obtained in a hypothetical risk capacity survey. The scale of measurement is on the left and the weighted average of each category is displayed in the column titled Overall Risk Capacity. Each category is assigned a numerical weight according to its contribution to risk capacity, and a weighted total score is then derived. In this case, it is a capacity level of 70. Table 10-1 is the allocation of indexes in Portfolio 70. This portfolio could now be regarded as this investor’s personal benchmark or the bull that can be ridden for the long run.
The “color of risk spectrum” was created to correlate with various levels of risk and return. The light and cool colors are at the low risk level and the darker, brighter and warmer colors are in the middle and high end of the risk scale. See Figures 10-8 and 10-9.
Figure 10-9
The results of the risk capacity survey provide a score between 1 and 100, indicating various risk capacity levels. In an effort to capture the life styles of 20 levels of risk capacity, we painted these paintings. Each are colored to represent a risk spectrum. Each painting conveys an age, family makeup, activities, careers, retirement and overall lifestyles.
The time horizon of an investment is one dimension of Risk Capacity. The longer investors hold a portfolio, the more likely it is that they will obtain the expected annualized return. Risk can be defined as the uncertainty of obtaining the expected return and quantified with the standard deviation measurement. As each year passes the standard deviation of annualized returns over the time period is reduced. If you look at Figure 10-10, you will see that as the time increases along the bottom scale, the uncertainty of expected annualized returns reduces over time on the left scale.
An average holding period for all 20 levels of risk capacity can be estimated. Figure 10-11 indicates that investors who score a 100 on the survey have a holding period of a minimum of 12 years (we have now updated that to 15 years, see the yellow stars on the chart below). Risk capacity scores of 50 have average holding periods of about eight years and at levels of five, the period is around three years. People scoring a 90 on the survey have about a 15-year average time horizon. For that reason, investors who fall within the 90 risk capacity score range should concentrate on the uncertainty of 15-year returns, not one year returns. So, instead of looking at the traditional efficient frontier of one year returns as seen in Figure 10-12, investors can capacity adjust their risk and stand the efficient frontier nearly straight up as seen on Figure 10-13. The chart shown in Figure 10-14 reinforces the concept of capacity adjusted risk. Investors who score a 90 on the Risk Capacity Survey should focus their time horizon on the 15-year holding period, the bell curve which can be seen below when you select Index Portfolio 90 and a 15 year holding period. When comparing the variation of 15-year annualized returns with the wide distribution of one-year annual returns, you can see the difference. Of course the wide range of outcomes can be constrained by the level of risk exposure in the index portfolio.
Figure 10-14
Figure 10-15 explains the concept of rolling period returns, which was also covered in Step 8. Note that the figure captures the experiences of different investors, such as those who may have invested on January 1955 (period #1) or in August 1955 (period 8). This method allows us to review 481 ten-year rolling periods from January 1955 to December 2006, as seen in the gold highlighted row in Figure 10-16. The data in this table represents rolling periods as shown in Figure 10-15. Note that in one-year rolling periods, the standard deviation of returns is 16.85% in column five. But 10-year rolling periods the standard deviation of annualized returns drops significantly to 4.03%, as seeen in the gold highlighted row. Also, shown is the lowest 10-year rolling period over that 50 years, which was January 1, 1965 to December 31, 1974, where the annualized return was 5.12%, which meant that one dollar grew to about $1.65 over that period. The highest annualized return of the 481 periods occurred on September 1, 1977 to August 31, 1987, where each dollar grew to $7.96 over the period.
If we look at how uncertainty of annualized returns are reduced over time for all 20 risk capacity levels and plot all this data on one big honkin’ chart, you get Figure 10-17. Appendix A provides an abundant amount of data about the 20 risk exposures that match the 20 risk capacities shown in this step. Figure 10-17 summarizes just about the entire concept and the enormous amounts of data contained in Appendix A.
Figure 10-17
"Option Theory Does Not Refute Time Diversification" -by Keith Redhead and Karl Shutes Click here to read the article abstract
Capacity adjusted risk is an entirely new way for investors to look at the uncertainty of their investments. One of its primary benefits is that it starts to get investors focused on a longer term prospective and not the daily, monthly, annual, or even three-year returns that detract investors from staying the course on their investment plan. For investors who honestly answer the questions in the Risk Capacity Survey, the risk of their investments can now be seen in a new perspective, adjusted for their capacity. Essentially, risk is held fairly constant for all investors as long as they adhere to the average time horizon of their risk capacity score. As explained above, that score measures dimensions beyond just time horizon, so that time is not the only consideration.
Please answer the following questions before moving on to the next Step:
1. A high score in the time horizon and liquidity needs dimension indicates that an investor:
a) needs immediate cash b) won’t need to withdraw money for six months to one year c) won’t need to withdraw money for one to three years d) won’t need to withdraw money for ten years or more
2. A low score in the attitude towards risk dimension indicates that an investor:
a) is willing to take a lot of risk b) most likely has a tendency to gamble c) is averse to risk and can’t stomach the thought of any loss
3. In addition to the Time Horizon and Liquidity Needs and Attitude toward Risk dimensions, the other risk dimensions are:
a) age, fund amount in a 401(k), and investment knowledge b) net worth, amount of equity in real estate, investment knowledge c) net worth, income and savings rate, investment knowledge d) income and savings rate, number of children in college, net worth