| |
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 | |
