Once the foundation and strategy of our Portfolios is understood, the only decision left is where should an investor be on the risk capacity versus risk exposure line. This is very important because returns are optimized when investors are on this line. Risk capacity can be estimated using the Risk Capacity Survey and risk exposure correlates to the 100 Index Portfolios (investment policies or asset allocations of indexes).

Where are you and your investments on the graph in Figure 1. If you do not know, your investments are equivalent to an uninformed guess or speculation. As shown in the chart, Index Portfolios with the lowest expected risk and return have higher allocations toward fixed income with a moderate investment in stocks. Conversely, Index Portfolios with the highest expected risk and return have less fixed income and more stocks and are tilted toward small companies and value companies in the U.S., International and Emerging Market.

Figure 1

The significant benefits associated with capturing the right amount of risk are elegantly displayed in Figure 2, which shows the growth of $1,000 in 100 different IFA Index Portfolios. 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, avoiding the rounding up or down of the analysis. As you can see, a small change in risk made a substantial difference in the growth of $1,000 over the 50+ year period. The chart also shows the growth of $1.00 and $100.00 over the same time period.

Figure 2

What's your Risk Capacity?

Calculating risk capacity is the first step to deciding which portfolio will generate optimal returns for each investor.

Each investor has a unique risk capacity and can be identified by a risk capacity score — a measure of
how much risk one can manage.

Determine Your Risk Capacity