Step 10

Introduction

Risk Capacity

Envision the market as a wild bull, bucking up and down, rearing and spinning. Investors are like bull riders, trying to hang on as the bull kicks and twists, making for a tumultuous ride. Matching the right portfolio to an individual's ability to handle risk is akin to finding the right bull that each investor can ride through all the ups and downs of the market.

Each investor has a unique risk capacity, one which  can be identified and quantified in a risk capacity score which is a measure of how much risk an individual can manage. This score is based on five specific dimensions of risk capacity: 1) time horizon and liquidity needs; 2) attitude toward risk; 3) net worth; 4) income and savings rate; and 5) investment knowledge.

Risk capacity can be regarded as a measurement of an investor's ability to earn stock market returns. Calculating risk capacity is the first step to deciding which portfolio will generate optimal returns for each investor. A risk capacity score determines the proper risk exposure for an investor's portfolio.

Improper Assessment of Risk Capacity

Many investors face the improper measurement of their risk capacity. Each of the five dimensions has to be carefully examined and quantified. Some dimensions carry more weight in the final score. The survey must be carefully designed, and investors must be accurate when answering the questions.

Risk Capacity Survey

An easy and efficient way to determine an investor's risk capacity is to complete a questionnaire or a survey that evaluates and quantifies each of the five dimensions of risk capacity. Several such survey can be found at ifarcs.com, which quantify risk capacity using numerical values from 1 to 100. These values correspond to various index portfolios created with the indexes referenced in Step 9.

Risk Capacity Results

Once an individual has completed a survey, an overall score is provided, which reflects that investor's capacity to take risk. An asset allocation of stocks and bonds with a risk exposure that properly matches the individual's risk capacity is also recommended.

Higher scores signify a higher capacity for risk, a longer time horizon and an ability to withstand market volatility. Investors with higher scores are generally recommended to hold portfolios with a larger allocation of global stocks. In contrast, lower scores signify a lower risk capacity and a higher need for liquidity. Investors with lower scores are steered toward more conservative portfolios that hold a higher proportion of short-term investments such as fixed income.

Time Horizon and Liquidity Needs

Time

Archimedes is often referenced as saying, "Give me a lever long enough and a place to stand, and I can move the earth." In the world of investing, that lever is time. The longer investors can hold onto their portfolios, the greater their risk capacity. Will an investor need 20% of the value of his investment portfolio in two years, five years, seven years, ten years, or longer? Usually, the closer a person is to retirement, the shorter his or her investment horizon becomes. Risk-calibrated index portfolios carry recommended holding periods that range from four to 15 years. The longer an investor holds onto a risky investment, the greater the chance of obtaining its average historical return and the greater the ability to reduce the uncertainty of these returns through time diversification.

Sample Risk Capacity Survey Question:

How many years will it be before you need to withdraw a total of 20% of all your investments for living or other expenses?

1. Less than 2 years
2. From 2 to 5 years
3. From 5 to 10 years
4. From 10 to 15 years
5. More than 15 years

Attitude Toward Risk

Attitude

This risk capacity dimension assesses aversion or attraction to risk, providing an estimation of an investor's willingness or ability to experience an investment loss. The last 86 years have shown that stock market investing can be a wild ride, with a lot of volatility and uncertainty. Investors who hold riskier investments can expect higher returns, but with greater volatility. Some people take less risk than they're actually capable of taking, preferring the tranquility of Ferdinand the Bull over the untamed violence of Crossfire Hurricane to carry them on their ride through the market.

Sample Risk Capacity Survey Question:

What is the worst twelve-month percentage loss you would tolerate for your long-term investments, beyond which you would be inclined to sell some or all of your investment?

1. A loss of 50%
2. A loss of 40%
3. A loss of 30%
4. A loss of 20%
5. A loss of 10%

Net Worth

Worth

What is the current value of an investor's long-term investments or golden nest egg? Net worth is the value of an investor's assets minus liabilities, or in other words, what is owned minus what is owed. Investors have a positive net worth when they own more than they owe. An individual's total net worth can provide a cushion against short-term stock market volatility and the uncertainty of future cash needs. Because life itself is a random walk, investors can never be completely certain of what their cash needs will look like tomorrow. The more assets in reserve, the greater the capacity for risk.

Sample Risk Capacity Survey Question:

What is the current value of your long-term investments? Please include your taxable accounts, retirement savings plan with your employer and your individual retirement accounts (IRAs).

1. Less than $25,000
2. $25,000 to $50,000
3. $50,000 to $100,000
4. $100,000 to $250,000
5. $250,000 or more

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 bolsters the ability to respond to emergencies without cashing out portfolio funds. Having to take money out of your portfolio after it has declined creates irreparable harm to your long-term returns. Having a solid income will minimize the chance you will need to dip into your retirement account. That is why this dimension is an important consideration when assessing risk capacity.

Sample Risk Capacity Survey Question:

What is your total annual income?

1. Less than $50,000
2. $50,000 to $100,000
3. $100,000 to $150,000
4. $150,000 to $250,000
5. $250,000 or more

Investment Knowledge

Knowledge

An individual who understands several key concepts that impact investing, such as the failure of active management, the Random Walk Theory, the Efficient Market Hypothesis, the Five-Factor Model, and Modern Portfolio Theory has a greater capacity for risk than someone without this understanding.

Sample Risk Capacity Survey Question:

The performance of stock pickers must be examined on an adjusted basis. When comparing the returns of a stock picker's portfolio to an appropriate index, which factors must be considered before determining if the stock picker has beaten the index?

1. Proper accounting of returns, including cash flows in and out of the account
2. Exposure to market, size, and value risk of both portfolios
3. A statistical analysis of the difference in returns with a measure of the significance of the difference, such as the t-stat
4. Standard deviations or volatility measurements
5. All of the above

An Investor's Role in Risk Capacity

When investors actively participate in the investment process by conducting the self-examination required to establish a risk capacity score, they better position themselves to weather appropriate levels of market volatility, thereby enhancing their ability to experience a high degree of investment success.