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Figure 10-15 explains the concept of rolling period returns, which was
also covered in Step 8. Note that the figure captures the experiences
of different investors, such as those who may have invested on January
1955 (period #1) or in August 1955 (period 8). This method allows us
to review 481 ten-year rolling periods from January 1955 to December
2006, as seen in the gold highlighted row in Figure 10-16. The data
in this table represents rolling periods as shown in Figure 10-15. Note
that in one-year rolling periods, the standard deviation of returns
is 16.85% in column five. But 10-year rolling periods the standard deviation
of annualized returns drops significantly to 4.03%, as seeen in the
gold highlighted row. Also, shown is the lowest 10-year rolling period
over that 50 years, which was January 1, 1965 to December 31, 1974,
where the annualized return was 5.12%, which meant that one dollar grew
to about $1.65 over that period. The highest annualized return of the
481 periods occurred on September 1, 1977 to August 31, 1987, where
each dollar grew to $7.96 over the period.
Figure
10-15
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Figure
10-16
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If
we look at how uncertainty of annualized returns are reduced over time
for all 20 risk capacity levels and plot all this data on one big honkin’
chart, you get Figure 10-17. Appendix A provides an abundant amount
of data about the 20 risk exposures that match the 20 risk capacities
shown in this step. Figure 10-17 summarizes just about the entire concept
and the enormous amounts of data contained in Appendix A.
Figure
10-17
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Capacity
adjusted risk is an entirely new way for investors to look at the uncertainty
of their investments. One of its primary benefits is that it starts
to get investors focused on a longer term prospective and not the daily,
monthly, annual, or even three-year returns that detract investors from
staying the course on their investment plan.
For investors who honestly answer the questions in the Risk Capacity
Survey, the risk of their investments can now be seen in a new perspective,
adjusted for their capacity. Essentially, risk is held fairly constant
for all investors as long as they adhere to the average time horizon
of their risk capacity score. As explained above, that score measures
dimensions beyond just time horizon, so that time is not the only consideration.
Matching people
with portfolios is a key component in assuring optimal returns. It is highly
recommended that an investor hold a portfolio that matches personal Risk
Capacity™. Risk Capacity™ can be determined by answering the
questions in the Risk Capacity™ survey at www.ifa.com, preferably
on an annual basis or when there are major changes in an investors
financial situation. Risk Capacity™ can be measured and determined
through five dimensions: time horizon and liquidity needs, attitude toward
risk, net worth, income and savings rate, and investment knowledge. The
larger the bucket for holding risk, the greater the expected returns. Investment
returns are entirely explained by Risk Capacity™, because capacity
is directly linked to proper risk exposure, also referred to as asset allocation
or investment policy. Asset allocation determines 100% of long-term returns.
1. A high
score in the time horizon and liquidity needs dimension indicates that
an investor:
a) needs
immediate cash
b) wont need to withdraw money for six months to one
year
c) wont need to withdraw money for one to three years
d) wont need to withdraw money for ten years or more

2. A low score
in the attitude towards risk dimension indicates that an investor:
a) is
willing to take a lot of risk
b) most likely has a tendency to gamble
c) is averse to risk and cant stomach the thought of
any loss

3. In addition
to the Time Horizon and Liquidity Needs and Attitude toward Risk dimensions,
the other risk dimensions are:
a) age,
fund amount in a 401(k), and investment knowledge
b) net worth, amount of equity in real estate, investment
knowledge
c) net worth, income and savings rate, investment knowledge
d) income and savings rate, number of children in college,
net worth


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