10.4.5 Capacity Adjusted Risk

The time horizon of an investment is one dimension of Risk Capacity. The longer investors hold a portfolio, the more likely it is that they will obtain the expected annualized return. Risk can be defined as the uncertainty of obtaining the expected return and quantified with the standard deviation measurement. As each year passes the standard deviation of annualized returns over the time period is reduced. If you look at Figure 10-10, you will see that as the time increases along the bottom scale, the uncertainty of expected annualized returns reduces over time on the left scale.

Figure 10-10

Figure 10-11

Figure 10-12

Figure 10-13

An average holding period for all 20 levels of risk capacity can be estimated. Figure 10-11 indicates that investors who score a 100 on the survey have a holding period of a minimum of 12 years. Risk capacity scores of 50 have average holding periods of about seven years and at levels of five, the period is around four years. People scoring a 90 on the survey have about a 10-year average time horizon. For that reason, investors who fall within the 90 risk capacity score range should concentrate on the uncertainty of 10-year returns, not one year returns. So, instead of looking at the traditional efficient frontier of one year returns as seen in Figure 10-12, investors can capacity adjust their risk and stand the efficient frontier nearly straight up as seen on Figure 10-13.

The Annualized Return Matrix shown in Figure 10-14 reinforces the concept of capacity adjusted risk. Investors who score a 90 on the Risk Capacity Survey should focus their time horizon on the 10-year diagonal, which is highlighted in the gold color on the return matrix presented in Figure 10-14. When comparing the variation of 10-year annualized returns with the variation of one-year annual returns along the top diagonal, you can easily see that time diversifies returns, as the markets goes through its random gyrations from year to year. Of course the gyrations can be constrained by the level of risk exposure in the index portfolio.

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

Figure 10-16

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

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.