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Each person has a unique Risk Capacity™.  The question is, how do we measure this capacity and find the right "bull" for you to ride?  "Holding risk" is like riding the bull, and the returns are the greatest for those with the highest capacity for staying on the bull market through the ups and downs.

Now that we have investigated the pitfalls of active investors, learned the language of Riskese™, and reviewed the history of various indexes, we are ready to move into the implementation phase of the 12-Step Program. This next process is what we call CEO Investing. CEO stands for capacity-exposure optimization and is the process that best matches people with portfolios. At the intersection of Risk Capacity™ and risk exposure sits a portfolio that will be optimal for each investor, and will therefore generate optimal returns (see Figure 10-1).

Each investor is entitled to a level of return that is commensurate with his Risk Capacity™. Based on this logic, the measurement of Risk Capacity™ can be elevated to a very high level of importance and can now be addressed as the first step in the implementation phase.

The reason investors only earn approximately five percent of market rate of returns is that their risk exposure is constantly moving from high to low. For example, if an investor has a Risk Capacity™ of 65% and selects a risk exposure of 35%, he is being overly conservative. When stock market returns start taking off, this investor feels he should further increase his risk exposure. What often occurs is he then moves his exposure up to 95%. At a higher exposure of 95%, the portfolio is required to have high volatility, which eventually scares the investor back down to a 35% exposure.

The optimal scenario for this investor is to choose a 65% exposure to match his 65% Risk Capacity™ and ride it. The market is like a wild bull trying to buck investors off its back. The objective of CEO investing is to find the bull each investor can stick with and ride until the buzzer sounds. In this analogy, the buzzer represents an investor's need to withdraw funds from his account.

There are five dimensions of Risk Capacity™. Each one can be carefully measured with a properly designed survey consisting of forty-nine questions, along with an expert in CEO investing. This thorough analysis is critical to pinpointing the optimal portfolio of index funds, which will provide the optimal returns for each investor.

The five dimensions for determining Risk Capacity™ are discussed in this step. Since all of long-term returns are determined by asset allocation or risk exposure, it is essential that each investor thoroughly understand the individual components of Risk Capacity™.

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" Design a portfolio you are not likely to trade... akin to premarital counseling advice; try to build a portfolio that you can live with for a long, long time." Is Your Beta Big Enough to Cover Your Taxes? [answer is NO] Robert D. Arnott, President, First Quadrant Corp.

"Risk Capacity™ is a measurement of your ability to earn stock market returns." Mark Hebner, President, Index Funds Advisors

The dimensions ofRisk Capacity™ can be broken down into five categories defined as follows.

Five Dimensions ofRisk Capacity™

Dimension 1: Time Horizon and Liquidity Needs

The Time Horizon and Liquidity Needs dimension estimates how rapidly investors may need to withdraw money from their investments. A low score indicates that an investor may need money in less than two years. A higher score indicates that an investor may not need to withdraw money for ten years or more. The longer an investor holds onto a risky asset with at least a twenty year record of associated returns, the less chance there is of obtaining a poor cumulative return. The time series graph will show you the importance of time horizon and how it relates to risk and return. Select different time periods and see how it affects the distribution of returns.

Dimension 2: Attitude Toward Risk

The Attitude Toward Risk dimension estimates aversion or attraction to risk. Risk is defined as "the possibility of loss," and this category addresses the ability to stomach the inevitable decline of any investment subject to risk. If it never declines, there is no risk and therefore no reason for the investment to earn a return. High returns are not available without accepting high risk. A high score suggests a capacity of tolerating high risk investing to obtain the potential for higher returns. A low score indicates a risk aversion and the need to invest more conservatively. High risk attitudes are derived from individual personality, experience, gaming inclination, or a number of other factors. Of all theRisk Capacity™ dimensions, this is the most difficult to quantify, as it is an intangible quality.

Dimension 3: Net Worth

The Net Worth dimension estimates capacity to take various levels of risk with investments. A high net worth provides a cushion for the uncertainty of future cash needs. Because life is a random walk, we are never certain of tomorrow's requirements. The more assets there are in reserve, the higher one's capacity is for risk. The higher the net worth, the higher the capacity for risk. (net worth calculator from dinkytown.net )

Dimension 4: Income and Savings Rate

The Income and Savings Rate dimension estimates excess income and ability to add to savings. A high score indicates that a large percentage of income is discretionary and is available for investing. A low score indicates that all or almost all income is being used for ordinary expenses and not being added to annual investments. A higher income also adds to the cushion for surprise or emergency cash requirements. net income calculator

Dimension 5: Investment Knowledge

The Investment Knowledge dimension estimates an investor's understanding of the 12-Step Program to Index Funds. A high score indicates a good understanding of the modern portfolio theory and the failure of active management. A low score indicates that a review of this 12-Step Program may be needed.

How important is investment knowledge? A recent study of 401k plans highlighted the Causes of Low Returns for 401k Plan Participants:

" The low returns also reflect a number of inherent failings in 401(k) plans as currently structured, involving participants, plan sponsors and the law.

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