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.