Page 1 Page 2 Page 3 Page 4 Page 5 Page 6 Click Here for Step 12






   
11.1
Introduction

Now that you understand risk capacity, the next step is to match the results of the risk capacity survey with a specific risk exposure. By doing this, investors position themselves to achieve personalized optimal returns. Not all investors have the capacity to expose their investments to high levels of risk; therefore, a continuum of risk exposures is needed to meet the unique risk capacities of each investor. This concept extends to larger institutional investments, such as fire and police pension plans, church funds, college endowments, and any other funds governed by committees.

Numerous studies including those by Gary Brinson, Ron Surz, and Roger Ibbotson have determined there is essentially only one decision that investors need to make: Which mix of indexes is best for them.

There are 20 premixed portfolios of indexes presented in this step. These portfolios have a specific percentage allocation of asset classes that match the 20 specific Risk Capacities. Figure 11-1 shows the asset class allocations of the 20 IFA Index Portfolios, labeled 5 through 100 in five-point increments. Each one is coupled with a specific risk capacity. Investors can be matched to one of these based on the results of Step 10’s Risk Capacity Survey.

Once investors determine their best mix, they or their investment advisor can determine which available index funds will best represent the chosen mix of indexes.

Figure 11-1

The mix of indexes in your portfolio, or your asset allocation, accounts for a little more than 100% of your total return on average. The "little more than" refers to the negative returns of active management. Active returns are near zero, but negative on average. (see article)* This is also referred to as your Investment Policy. As Charles Ellis points out in his 1985 classic, Investment Policy, it is the most important choice an investor can make. In this Step, we will review various mixtures of risk exposures and show the long- term historical returns of those portfolios. Now that you have established a Risk Capacity™, you need to evaluate risk before actually taking it. This will complete the matching of Risk Capacity™ (people) and risk exposure (portfolios).

Numerous studies, including one by the worldwide accounting firm PriceWaterhouseCoopers , conclude that index funds will best achieve an investor's goals, making them a perfect way to implement your Risk Exposure. This concept is even incorporated into legal guidelines, under the Prudent Investor Rule. 

Prudent Investor Rule

In 1992 The American Law Institute published Restatement of the Law, Trust, Prudent Investor Rule. This is meant as a guideline for the prudent management of trust assets.

In 1995, the National Conference of Commissioners on the Uniform State Laws adopted the Uniform Prudent Investor Act as a guideline for states to create their individual laws. It has been made into law in many states. In California it became law in 1996 under the title of the Uniform Prudent Investor Act. (Also see here.) This rule points out the value of Modern Portfolio Theory. It essentially tells trustees that index funds are the prudent way to invest trust assets. The rule acts as a legal road map for estate planning attorneys, trustees of all types of trusts, and investment advisors.

The Reporter's Notes to the Prudent Investor Rule point out the problems with active management.

"Economic evidence shows that from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to 'beat the market' in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirica