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Dimension 1: Time Horizon and Liquidity Needs 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 Attitude Toward Risk dimension estimates aversion or attraction to risk. Risk is defined as "the possibility of loss," and this category addresses the ability to stomach the inevitable decline of any investment subject to risk. If it never declines, there is no risk and therefore no reason for the investment to earn a return. High returns are not available without accepting high risk. A high score suggests a capacity of tolerating high risk investing to obtain the potential for higher returns. A low score indicates a risk aversion and the need to invest more conservatively. High risk attitudes are derived from individual personality, experience, gaming inclination, or a number of other factors. Of all the Risk Capacity™ dimensions, this is the most difficult to quantify, as it is an intangible quality. Figure 10-2 shows the relationship between risk attitude, time horizon, and optimal portfolios.
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.
Net WorthYour 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. Definitions
Dimension 4: Income and Savings Rate  The Income and Savings Rate dimension estimates excess income and ability
to add to savings. A high score indicates that a large percentage of
income is discretionary and is available for investing. A low score indicates
that all or almost all income is being used for ordinary expenses and
not being added to annual investments. A higher income also adds to the
cushion for surprise or emergency cash requirements. See the net income
calculator for Home Budget Calculator below. Figure 10-3 shows the relationship
between net worth, net income, and optimal portfolios. For a detailed
analysis of retirement planning, see
netirement.com. (Wealthcare) Home Budget AnalysisManaging 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. Definitions
Dimension
5: Investment Knowledge
How important is investment knowledge? A recent study of 401k plans highlighted the Causes of Low Returns for 401k Plan Participants: "The low returns also reflect a number of inherent failings in 401(k) plans as currently structured, involving participants, plan sponsors and the law. Problem: Lack of Knowledge. Several studies find that many participants in defined contribution plans have an appalling lack of understanding of basic principles of investing. For example, a recent national survey of participants found: 1. Respondents generally considered company stock less risky than a diversified domestic equity portfolio. 2. 44 percent thought money market funds included stocks and 43% thought they also included bonds. 3. Nearly 20% didn't know they could lose money in equities. 4. 65% didn.t know they could lose money in a bond fund and 60% didn't know they could lose money in a government bond fund. Small wonder that so many participants in 401(k) plans have little or no grasp of the principles of prudent investing! They may have a limited or extensive list of funds from which to choose, but they base their selection on individual funds rather than investment strategy. The fund offerings may not stress the value of index funds, which invest in the stocks or bonds used to compute a particular index and have low management fees because they are not actively managed. Participants take too little risk, as in the case of those letting most of their assets stay in money market funds or cash, or too much risk, as in the case of those putting the great majority of their assets into high-tech stocks or funds. Many participants have an appalling lack of understanding of basic principles of investing." (Source: Reinventing Retirement Income in America by Brooks Hamilton and Scott Burns, NCPA Policy Report No. 248 December 2001 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 (click
here for a Acrobat Reader print out in pdf format).
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. 10.3.2
Risk Capacity™ Changes Over Time 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.
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
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 $25,000 3. What is your total annual income after the deduction of taxes? a. Less than $50,000
4. What is the worst twelve month unrealized percentage loss you would tolerate for your long-term investments? a. -50% 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 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. |
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