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The optimal investment is a globally diversified, tax-managed, and small and value tilted, mix of
index funds (risk exposure) matched to your unique risk capacity, referred to as CEO Investing: Capacity-Exposure Optimization.
Index funds (either mutual or exchange traded) are funds with clearly defined sets of rules of ownership, that are adhered to regardless of market conditions. There are about 1,000 index funds available to investors. We like many of them, but our current favorite are the index funds or passively managed funds from Dimensional Fund Advisors (DFA).
IFA offers 100 Index Portfolios, which are individualized and indexed. The Index Portfolios are allocated among three broad asset
classes: fixed income (bonds); U.S. stocks; and foreign stocks (see a sample of 20 Index Portfolios in Figure 1). The
stocks are further divided by size and value (book-to-market ratio).
According to the Financial
Economists Roundtable, index portfolios are the best
estimates of the principal risk factors that are likely to influence
fund risks and returns in the future.
Once the above article is understood, the only decision left is where should an investor be on the risk capacity versus risk exposure line. This is very important because returns are optimized when investors are on the line. Risk capacity can be estimated using the Risk Capacity Survey and risk exposure correlates to the 100 Index Portfolios (investment policies or asset allocations of indexes).
Where are you and your investments on the graph in Figure 2. If you do not know, your investments are equivalent to an uninformed guess or speculation. As shown in the chart, Index Portfolios with the lowest expected risk and return have higher allocations toward fixed income with a moderate investment in stocks. Conversely, Index Portfolios with the highest expected risk and return have less fixed income and more stocks and are tilted toward small companies and value companies in the U.S., International and Emerging Market.
The Risk Return Table below includes standard deviations for twenty Index Portfolios. Standard deviation expresses the spread of individual observations around the mean or average. A standard deviation is the square root of the variance. Variance is the measure of the spread of variability of quantitative measurements.
In other words, the standard deviation is a statistic measurement that tells you how tightly the various annual returns are clustered around the average. When the annual returns are pretty tightly bunched together the standard deviation is small and the bell-shaped curve is narrow. When the annual returns are spread apart and the bell curve is relatively flat, it tells you that you have a relatively large standard deviation.
The combination of the average and the standard deviation characterize various bell curve shapes and those shapes represent the risk and return of the Index Portfolio. Figure 3 shows you graphically what a standard deviation represents.
The standard error of the mean indicates the degree of uncertainty in calculating an estimate from a sample, like a series of returns data. A standard error can be calculated from the standard deviation by dividing the standard deviation by a square root of the sample size. So with only 3 years of returns data on the S&P 500, the error in the average return is 2.6 times larger than having 20 years of data.
The significant benefits associated with capturing the right amount of risk are elegantly displayed in Figure 4, which shows the growth of $1,000 in 100 different Index Portfolios over the 50+ year time period from January 1961 through October 2012. Each of these engineered portfolios is designed with different blends of equities and fixed income. This continuum of risk and return provides investors the opportunity to invest in a targeted asset allocation that matches their risk capacity score between 1 and 100. The chart further validates the value of carefully matching an investor's risk capacity to a corresponding risk exposure, avoiding the rounding up or down of the analysis. As you can see, a small change in risk made a substantial difference in the growth of $1,000 over the 50+ year period. The chart also shows the growth of $1.00 and $100.00 over the same time period.
|Below are methods for implementing each level of risk.|
Figure 7 - Original
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