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.