Step 10: Risk Capacity

Risk Capacity
Analyze your five dimensions of risk capacity
10.4.2

The Investment Meter

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.


Figure 10-5
Ten Dimensions of 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.

Figure 10-6
5 Dimensions of Risk Capacity
Figure 10-7
5 Dimensions of Risk Exposure

*All indexes are unmanaged, annually rebalanced and include reinvestment of dividends and distributions. Investors can not rely directly in these indexes. The information above is provided for illustrative purposes only and is not intended to imply the future performance of any investments mentioned, nor does it reflect any advisory fees or transaction costs. Past performance is not indicative of future performance. Source: DFA Returns Programs. Link to Sources and Descriptions of Data

Table 10-1IFA Index Portfolio 70
  

10.4.3

The Color of Risk Spectrum


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 10-8
The Color Risk Spectrum

Figure 10-9

Color of Risk Spectrum Used for Risk Capacity and Risk Exposure

10.4.4

Twenty Risk Capacities


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.


20 Risk Capacity Paintings

Risk Capacity 100
Risk Capacity 95
Risk Capacity 90
Risk Capacity 85
Risk Capacity 80
Risk Capacity 75
Risk Capacity 70
Risk Capacity 65
Risk Capacity 60
Risk Capacity 55
Risk Capacity 50
Risk Capacity 45
Risk Capacity 40
Risk Capacity 35
Risk Capacity 30
Risk Capacity 25
Risk Capacity 20
Risk Capacity 15
Risk Capacity 10
Risk Capacity 5

10.4.5

Capacity Adjusted Risk

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.

Figure 10-10
Uncertainty of Expected Returns Reduced by Time Diversification		 Figure 10-11
Uncertainty of Expected Return Adjusted for Risk Capacity

Figure 10-12
Annualized expected Return and One Year Risk		 Figure 10-13
Annualized Expected Return and Capacity Adjusted Risk


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.

Figure 10-15
Explanation of 10-Year Rolling Periods

Figure 10-16Monthly Rolling Period Analysis

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.


10.5

Summary


Matching people with portfolios is a key component in assuring optimal returns. It is highly recommended that an investor hold a portfolio that matches personal Risk Capacity™. Risk Capacity™ can be determined by answering the questions in the Risk Capacity™ survey at www.ifa.com, preferably on an annual basis or when there are major changes in an investor’s financial situation. Risk Capacity™ can be measured and determined through five dimensions: time horizon and liquidity needs, attitude toward risk, net worth, income and savings rate, and investment knowledge. The larger the bucket for holding risk, the greater the expected returns. Investment returns are entirely explained by Risk Capacity™, because capacity is directly linked to proper risk exposure, also referred to as asset allocation or investment policy. Asset allocation determines 100% of long-term returns.

10.6

Review Questions


become a certified indexer

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

    answer button

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

    answer button

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

    answer button

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