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