Step 10: Risk Capacity

Risk Capacity
Analyze your five dimensions of risk capacity

 10.2

Definitions


10.2.1

Five Dimensions of Risk Capacity™

Mark Hebner explains the five dimensions of Risk Capacity in this video.

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


Dimension 1: Time Horizon and Liquidity Needs


Time

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


Attitude


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 Risk Capacity Dimensions

Dimension 3: Net Worth


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. See the net worth calculator below.

Net Worth

Your 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.

 

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Definitions

Home
Current value of your home. This should be as close as possible to the actual market value of your home. If you have owned your home for a number of years, the current market value could be significantly higher than your original purchase price.

Other real estate
The value of any other real estate you may own. Include second homes, undeveloped land, rental property or any commercial buildings you may have an interest in. As with your home, use the actual market value of this real estate.

Automobiles
This is the total value of all automobiles that you own. Do not include any leased vehicles.

Other vehicles
If you own any other vehicles, such as RVs, campers or collectibles, enter them here.

Jewelry
The value of any jewelry, gems or precious metals such as gold. If you have owned these items for a number of years they may have appreciated in price, remember to use the current market value.

Household items
The value of your household goods and items. This would include items such as furniture, home electronics, silverware, etc.

Retirement accounts
The current total balance of your retirement accounts. This should include IRAs, 401(k) savings, SEP IRAs, variable annuities and any other retirement savings you may have.

Bonds
If you own any Treasury, municipal, or commercial bonds enter the total here.

Stocks
If you own any individual stocks, enter the total here. Again, do not include any stocks that are held in a retirement account.

Mutual funds
If you own any mutual funds, enter the total here. Do not include any mutual funds that are in your retirement accounts, they were already included in the "Retirement accounts" line.

Cash value of life insurance
Some life insurance has a cash value. This is true for Whole Life and Universal Life policies. Term Life policies, on the other hand, have no cash value. If you have life insurance with a cash value, enter the total here. Remember, this should be the cash value of the policy, not the amount paid out if you were to collect on the policy.

Savings bonds
If you own any Savings Bonds enter the total here.

Checking and savings
The current total balance of your checking and savings accounts.

Cash
If you have any other cash, enter the total here.

Other
If you have any other assets of value, you can enter the total here.

Home mortgage principal
This is the current principal balance remaining on your mortgage. This is the amount that you would have to pay to own your home free and clear.

Other mortgage principal
This is the current principal balance for any other real estate mortgages you may have. This includes mortgages on rental property, undeveloped land, commercial property or any other real estate.

Auto loans
Total amount you currently have outstanding on your auto loans.

Student loans
Total amount, if any, that you currently owe in college or student loans. You should enter the total outstanding even if these loans are currently in deferment.

Credit card debt
Your total credit card debt.

Other loans
Total amount, if any, of any other loans you may have.

Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.


Dimension 4: Income and Savings Rate



Income

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.
Figure 10-3Net Worth and Net Income

Home Budget Analysis

Managing 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.

 

This Financial Calculator requires SUN's Java™ Plug-in. If you see this message you will need to download SUN's Java™ Plug-in. This can be done automatically by clicking the yellow bar at the top of your browser and choosing “Install ActiveX Control”.

    You can also get SUN's Java™ Plug-in here: Get the Java™ Plug-in!

Definitions

Your income
Your total gross income from your paycheck.

Other income
Any other income that you receive including bonuses, alimony, child support or income from a business.

Federal tax withholding
Total amount withheld for federal taxes. Enter this amount from your pay stub.

State tax withholding
Total amount withheld for state taxes. Enter this amount from your pay stub.

Local tax withholding
Total amount withheld for local taxes. Enter this amount from your pay stub.

Other taxes and withholdings
Total amount withheld for any other taxes or miscellaneous item. Enter this amount from your pay stub.

FICA
Total withheld for FICA (Federal Insurance Contributions Act) is based on the gross income on your paycheck.

Medicare
Total withheld for Medicare based on the gross income on your paycheck.

Insurance and benefits
Total amount withheld for insurance and benefits by your employer. Enter this amount from you pay stub.

Company retirement savings plan
Total amount withheld from your paycheck that is deposited into a company retirement savings plan such as a 401(k) or 403(b).

Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.

Dimension 5: Investment Knowledge



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.
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.
Figure 10-4
Investment Knowledge & the 12-Step Program
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.


Five Dimensions of Risk Capacity:


Five Dimensions of Risk Capacity

Matched to Five Dimensions of Risk Exposure


Risk Exposure


10.3

Problems


10.3.1

Investors Do Not Properly Assess Risk Capacity™

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.


10.4

Solutions


10.4.1

The Risk Capacity™ Survey

Which portfolio of index funds is right for you?The five dimensions of Risk Capacity™ are measured through a Risk Capacity™ survey that poses several questions to the investor. This survey is the single most important step of the investment planning process. Index Funds Advisors offers three surveys on their website at www.ifa.com. The complete survey includes twenty five questions, the 401(k) survey has nineteen questions, and the quick survey is comprised of five questions. Based on the answers from the two longer surveys, a thorough analysis is generated. The quick survey is designed to provide an overview of the five dimensions and should not be relied on for determining asset allocation, unless the answers are discussed with an investment advisor. The quick survey asks the following five questions:  

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
b. more than 2 but less than 5 years
c. more than 5 but less than 10 years
d. more than 10 but less than 15 years
e. more than 15 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 $50,000
b. $50,000 to $100,000
c. $100,000 to $150,000
d. $150,000 to $250,000
e. $250,000 or more

3. What is your total annual income after the deduction of taxes?

a. Less than $50,000
b. $50,000 to $75,000
c. $75,000 to $99,999
d. $100,000 to $199,999
e. $200,000 or more

4. What is the worst twelve month unrealized percentage loss you would tolerate for your long-term investments?

a. -50%
b. -40%
c. -30%
d. -20%
e. -10%

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
b. below average
c. average
d. above average
e. expert

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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