The Five Dimensions of Risk Capacity

IFA Sustainable believes that a problem many investors face is the improper measurement of their risk capacity. As a result, the overwhelming majority of investors fail to earn the returns of even a simple S&P 500 Index over periods of ten or more years. Each of the five dimensions of risk should be carefully examined and then quantified. Some dimensions carry more weight in the determination of a final score. The survey must be carefully designed, and investors must be honest and accurate when answering the questions.

An easy and efficient way to determine an investor's risk capacity is to complete our survey that evaluates and quantifies each of the five dimensions of risk capacity:

Dimension 1 | Time Horizon and Liquidity Needs
The longer investors can hold on to their portfolios, the greater their risk capacity. Will an investor need 20% of the value of his investment portfolio in two years, five years, seven years, ten years, or longer? Usually, the closer a person is to retirement, the shorter his or her investment horizon becomes. Risk-calibrated index portfolios carry recommended holding periods that range from four to fifteen years. The longer an investor holds onto a risky investment, the greater the chance of obtaining its average historical return and the greater the ability to reduce the uncertainty of these returns through time diversification.

Dimension 2: Attitude Towards Risk
This risk dimension assesses aversion or attraction to risk, providing an estimation of an investor's willingness or ability to experience an investment loss. The last 50 years have shown that stock market investing can be a wild ride, with a lot of volatility and uncertainty. Investors who hold riskier investments can expect higher returns, but greater short-term volatility. Some people take less risk than they're actually capable of taking, or oftentimes far more risk then they realize, both of which can harm the overall investor experience.

Dimension 3: Net Worth
What is the current value of an investor's long-term investments or golden nest egg? Net worth is the value of an investor's assets minus liabilities, or in other words, what is owned minus what is owed. Investors have a positive net worth when they own more than they owe. An individual's total net worth can provide a cushion against short-term stock market volatility and the uncertainty of future cash needs. Because life itself is a random walk, investors can never be completely certain of what their cash needs will look like tomorrow. The more assets in reserve, the greater the capacity for risk.

Dimension 4: Income and Saving 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 bolsters the ability to respond to emergencies without cashing out portfolio funds. Having to take money out of your portfolio after it has declined creates irreparable harm to your long-term returns. Having a solid income will minimize the chance you will need to dip into your retirement account. That is why this dimension is an important consideration when assessing risk capacity.

Dimension 5: Investment Knowledge
The Investment Knowledge dimension estimates an investor's understanding of basic investment principles as well as advances in modern portfolio theory. A high score indicates a good understanding of Modern Portfolio Theory and the pitfalls of active management. Sufficient knowledge of time-tested and statistically proven investment theories provides peace of mind and encourages a buy and hold passive strategy.