Matching Risk Capacity to Risk Exposure

Unlike horseshoes, close enough isn't good enough for investors who want to maximize their ability to capitalize on the tradeoff between risk and return. For this reason, when selecting a risk exposure, the primary consideration should be identifying and investing in a blend of indexes that most closely matches risk capacity.

An investor's optimal strategy is to invest in a portfolio that directly corresponds to a particular risk capacity, capturing every available increment of risk exposure. This more refined approach enables investors to take on just the right amount of risk, allowing them to identify an appropriate portfolio.

The benefits associated with capturing just the right amount of risk are displayed in Figure 11-9, which shows the growth of $1,000 in 100 different index portfolios over the 50 years from 1966 through end of 2015. Each of these engineered portfolios is designed with different blends of equities and fixed income. This continuum of risk and return provides investors the opportunity to invest in a targeted asset allocation that matches their risk capacity score between 1 and 100. The chart further validates the value of carefully matching an investor's risk capacity to a corresponding risk exposure. As you can see, a small change in risk made a substantial difference in the growth of $1,000 over this 50-year period.

Figure 11-9

Step 11Risk ExposureRisk CapacityAsset Allocation