We’ve all seen the warnings. Past performance is not a reliable indicator of future returns. The value of an investment can go down as well as up. You might not get back the amount you invested.

Risk is a part of the game in investing, but it’s hard to see and easy to forget about. That is partly why many fund managers often construct an Investment Policy Statement (IPS) for their clients. These statements are intended to spell out a client’s investment objectives and constraints. Sounds basic - and it is - but how many of us actually do anything like this ourselves?

Applying aspects of the IPS to our own situations might allow us to better articulate and justify our investing strategies. The first step would be to describe your situation in a brief client description. This might include your age, employment status, and any dependents. 

Once that is sketched out, it is time to write down in greater detail your investment objectives and constraints.

Constraints

Two big constraints on investment strategy are liquidity and time horizon.

Say a meteorite crashes through the conservatory roof one night and you have to shell out for repairs. If this kind of eventuality hasn’t been factored into your strategy and you have invested in illiquid micro caps, you might then have to sell stock at a distressed price in order to restore your mess of a house. Unfortunately, you are now a victim of liquidity risk (as well as an errant asteroid).

This kind of risk is better off avoided by considering your potential liquidity requirements and comparing them against the size of your portfolio, the amount of income it generates, and how much you earn. Liquidity risk is why some people keep a rainy day fund in their bank accounts or a minimum amount of their portfolios in cash and other liquid assets.

Time horizon is also an important consideration. A 30-year-old investor at the start of his or her career can probably afford to take more risk than somebody with the same amount of money who is about to retire. It is worth considering how your time horizon modifies your ability to take risk. The resulting conclusion might also affect your asset allocation. A shorter time horizon and lower risk tolerance might mean a more diversified equity portfolio and a greater weighting in assets like highly…

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