The
investment meter is a device that shows the scores of the five dimensions
as percentages of the maximum possible for each category. It is another
way to look at Risk Capacity™ and the resulting risk exposure. Each
category is assigned a numerical weight according to its estimated contribution
to Risk Capacity™, and a weighted total score is then derived. The bar chart below shows your results in each category, and
your overall Risk Capacity™. Each category result is shown as a
percentage of the maximum possible for that category. Then each category
is assigned a numerical weight according to its estimated contribution
to your capacity for risk and added for the weighted total score, also
shown as a percentage of the maximum possible. A weighted total score
of 100 indicates the highest capacity for risk.
Figure
10-5
The 10 dimensions
of risk are shown in Figure 10-5 and the method of measuring and weighting
the categories are depicted in the investment meters in Figures 10-6 and
10-7. In Figure 10-6, an individual’s five dimensions of capacity
are shown with a meter depicting the scores obtained in a hypothetical
risk capacity survey. The scale of measurement is on the left and the
weighted average of each category is displayed in the column titled Overall
Risk Capacity. Each category is assigned a numerical weight according
to its contribution to risk capacity, and a weighted total score is then
derived. In this case, it is a capacity level of 70. Table 10-1 is the
allocation of indexes in Portfolio 70. This portfolio could now be regarded
as this investor’s personal benchmark or the bull that can be ridden
for the long run.
Figure
10-6
Figure
10-7
*All
indexes are unmanaged, annually rebalanced and include reinvestment of dividends
and distributions. Investors can not rely directly in these indexes. The
information above is provided for illustrative purposes only and is not
intended to imply the future performance of any investments mentioned, nor
does it reflect any advisory fees or transaction costs. Past performance
is not indicative of future performance. Source: DFA Returns Programs. Link
to Sources and Descriptions of Data
The “color
of risk spectrum” was created to correlate with various levels of
risk and return. The light and cool colors are at the low risk level and
the darker, brighter and warmer colors are in the middle and high end
of the risk scale. See Figures 10-8 and 10-9.
The results of the
risk capacity survey provide a score between 1 and 100, indicating various risk capacity levels. In an effort to capture
the life styles of 20 levels of risk capacity, we painted these paintings. Each are colored to represent a
risk spectrum. Each painting conveys an
age, family makeup, activities, careers, retirement and overall lifestyles.
The
time horizon of an investment is one dimension of Risk Capacity. The
longer investors hold a portfolio, the more likely it is that they will
obtain the expected annualized return. Risk can be defined as the uncertainty
of obtaining the expected return and quantified with the standard deviation
measurement. As each year passes the standard deviation of annualized
returns over the time period is reduced. If you look at Figure 10-10,
you will see that as the time increases along the bottom scale, the
uncertainty of expected annualized returns reduces over time on the
left scale.
Figure
10-10
Figure
10-11
Figure
10-12
Figure
10-13
An average holding period for all 20 levels of risk capacity can be
estimated. Figure 10-11 indicates that investors who score a 100 on
the survey have a holding period of a minimum of 12 years (we have now updated that to 15 years, see the yellow stars on the chart below). Risk capacity
scores of 50 have average holding periods of about eight years and at
levels of five, the period is around three years. People scoring a 90
on the survey have about a 15-year average time horizon. For that reason,
investors who fall within the 90 risk capacity score range should concentrate
on the uncertainty of 15-year returns, not one year returns. So, instead
of looking at the traditional efficient frontier of one year returns
as seen in Figure 10-12, investors can capacity adjust their risk and
stand the efficient frontier nearly straight up as seen on Figure 10-13.
The chart shown in Figure 10-14 reinforces the concept
of capacity adjusted risk. Investors who score a 90 on the Risk Capacity
Survey should focus their time horizon on the 15-year holding period, the bell curve which
can be seen below when you select Index Portfolio 90 and a 15 year holding period. When comparing the variation of 15-year annualized returns with
the wide distribution of one-year annual returns, you can see the difference. Of course the wide range of outcomes can
be constrained by the level of risk exposure in the index portfolio.
Figure 10-14
Figure 10-15 explains the concept of rolling period returns, which was
also covered in Step 8. Note that the figure captures the experiences
of different investors, such as those who may have invested on January
1955 (period #1) or in August 1955 (period 8). This method allows us
to review 481 ten-year rolling periods from January 1955 to December
2006, as seen in the gold highlighted row in Figure 10-16. The data
in this table represents rolling periods as shown in Figure 10-15. Note
that in one-year rolling periods, the standard deviation of returns
is 16.85% in column five. But 10-year rolling periods the standard deviation
of annualized returns drops significantly to 4.03%, as seeen in the
gold highlighted row. Also, shown is the lowest 10-year rolling period
over that 50 years, which was January 1, 1965 to December 31, 1974,
where the annualized return was 5.12%, which meant that one dollar grew
to about $1.65 over that period. The highest annualized return of the
481 periods occurred on September 1, 1977 to August 31, 1987, where
each dollar grew to $7.96 over the period.
Figure
10-15
Figure
10-16
If
we look at how uncertainty of annualized returns are reduced over time
for all 20 risk capacity levels and plot all this data on one big honkin’
chart, you get Figure 10-17. Appendix A provides an abundant amount
of data about the 20 risk exposures that match the 20 risk capacities
shown in this step. Figure 10-17 summarizes just about the entire concept
and the enormous amounts of data contained in Appendix A.
Capacity
adjusted risk is an entirely new way for investors to look at the uncertainty
of their investments. One of its primary benefits is that it starts
to get investors focused on a longer term prospective and not the daily,
monthly, annual, or even three-year returns that detract investors from
staying the course on their investment plan.
For investors who honestly answer the questions in the Risk Capacity
Survey, the risk of their investments can now be seen in a new perspective,
adjusted for their capacity. Essentially, risk is held fairly constant
for all investors as long as they adhere to the average time horizon
of their risk capacity score. As explained above, that score measures
dimensions beyond just time horizon, so that time is not the only consideration.
Matching people
with portfolios is a key component in assuring optimal returns. It is highly
recommended that an investor hold a portfolio that matches personal Risk
Capacity™. Risk Capacity™ can be determined by answering the
questions in the Risk Capacity™ survey at www.ifa.com, preferably
on an annual basis or when there are major changes in an investor’s
financial situation. Risk Capacity™ can be measured and determined
through five dimensions: time horizon and liquidity needs, attitude toward
risk, net worth, income and savings rate, and investment knowledge. The
larger the bucket for holding risk, the greater the expected returns. Investment
returns are entirely explained by Risk Capacity™, because capacity
is directly linked to proper risk exposure, also referred to as asset allocation
or investment policy. Asset allocation determines 100% of long-term returns. 10.6
1. A high
score in the time horizon and liquidity needs dimension indicates that
an investor:
a) needs
immediate cash
b) won’t need to withdraw money for six months to one
year
c) won’t need to withdraw money for one to three years
d) won’t need to withdraw money for ten years or more
2. A low score
in the attitude towards risk dimension indicates that an investor:
a) is
willing to take a lot of risk
b) most likely has a tendency to gamble
c) is averse to risk and can’t stomach the thought of
any loss
3. In addition
to the Time Horizon and Liquidity Needs and Attitude toward Risk dimensions,
the other risk dimensions are:
a) age,
fund amount in a 401(k), and investment knowledge
b) net worth, amount of equity in real estate, investment
knowledge
c) net worth, income and savings rate, investment knowledge
d) income and savings rate, number of children in college,
net worth
