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10.2
Definitions

The dimensions of Risk Capacity™ can be broken down into five categories defined as follows.

10.2.1 Five Dimensions of Risk Capacity™


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.




 

      
Dimension 2: Attitude Toward Risk

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.

Figure 10-2

      Dimension 3: Net Worth
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. (net worth calculator from dinkytown.net )

      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. net income calculator 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)

Figure 10-3
Dimension 5: Investment Knowledge
The Investment Knowledge dimension estimates an investor’s understanding of the 12-Step Program to Index Funds. A high score indicates a good understanding of Modern Portfolio Theory and the failure of active management. A low score indicates that a review of this 12-Step Program may be needed. See Figure 10-4.
Figure 10-4

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