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Now that you understand risk capacity, the next step is to match the results of the risk capacity survey with a specific risk exposure. By doing this, investors position themselves to achieve personalized optimal returns. Not all investors have the capacity to expose their investments to high levels of risk; therefore, a continuum of risk exposures is needed to meet the unique risk capacities of each investor. This concept extends to larger institutional investments, such as fire and police pension plans, church funds, college endowments, and any other funds governed by committees.

Numerous studies including those by Gary Brinson, Ron Surz, and Roger Ibbotson have determined there is essentially only one decision that investors need to make: Which mix of indexes is best for them.

There are 20 premixed portfolios of indexes presented in this step. These portfolios have a variety of different names including index portfolios, asset class allocations, investment policy statements, model portfolios, lifestyle funds, and risk exposures. Although different names are used, the portfolios are essentially identical. Figure 11-1 shows these index portfolios, labeled 5 through 100 in five-point increments. Each one is coupled with a specific risk capacity. Investors can be matched to one of these based on the results of Step 10’s Risk Capacity Survey.

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" Investment planning is about structuring exposure to risk factors. " Gene Fama, Jr., The Error Term, Dec, 2001

" Investment Policy [asset allocation] is the foundation upon which portfolios should be constructed and managed. " Charles D. Ellis, author of Investment Policy, 1985

" 'Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket. " Miguel de Cervantes (1547-1616), Author of Don Quixote

" Risk is good. Not properly managing your risk is a dangerous leap " Evel Knievel, Motorcyclist

" History shows that in the long run a thoughtfully designed, diversified strategy of "passive" funds typically beats all but a few active managers. It's not easy to structure and maintain such a strategy. It requires some initial research and discipline to stay the course. But it's much easier than predicting which active managers will randomly beat this approach. " Eugene Fama, Jr., DFA

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Modern Portfolio Theory

One day in the early 1950s, a Ph.D. candidate in economics sat in the library at the University of Chicago. The young man, Harry Markowitz, was studying leading investment guides used by professional money managers. The guides seemed to recommend that an investor should invest in stocks with the highest expected return and ignore all the rest. After awhile, it suddenly occurred to Markowitz that investors should consider risk as well as return.

It was a simple conclusion; however, it spawned one of the most important investment ideas of the 20th Century, and has generated a whole body of scholarly work known as “Modern Portfolio Theory.” Thirty-eight years later it earned Markowitz a Nobel Prize in Economics. The fact that trillions of dollars around the globe are now invested and managed according to the principle proposed by Markowitz is testament to its central importance in the investment process. This revolutionary insight has not only transformed the investment world of corporate and government pension plans, insurance companies, banks and other large institutional investors, it has also changed the way individual investors invest

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