how to invest using investor policy statement

Only 1 of these 3 Types of Investors Makes Money, Which are You?

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Learn how to use an investor policy statement (IPS) to take the worry out of reaching your financial goals

There are three types of investors.

The first type of investor puts money in stocks, maybe even a little in some bond funds. They know they need to invest for the future but really have no idea how much they need or what kind of an annual return will get them to those goals.

That investor usually puts nearly everything in stocks. Why not? If you don’t know what kind of a return you need, why not go for the highest return possible?

They are also the one that ends up buying in as the stock market surges only to freak out and panic sell when the market crashes. Thousands are lost and they never reach their goals.

The second type of investor puts together an Investor Policy Statement (IPS). It details their goals, how much risk they are comfortable taking and the return they need to reach their magic number in retirement.

They plan out their investments according to the return they need, usually with a large chunk in stocks to reach a high return, and start daydreaming about Pina Coladas in their retirement paradise.

That investor too gets caught in some future stock market crash. It turns out, they didn’t really understand how to change their investments according to changing needs. They may not lose as much as the first investor but those Pina Colada dreams turn into to sipping RC Cola in a small apartment.

The third type of investor not only creates an IPS but understands how to use their investing policy and how it changes over the years. This investor is ready for everything the market throws at them and ends up with enough money to buy Pina Coladas for everyone.

how to invest using investor policy statementBe the third investor!

In this part of the course, we’ll talk about putting your investor policy statement in action. I’ll highlight how to know if the return you need to meet your financial goals is too high and what you can do about it.

I’ll also talk about how to find the best investments for your plan, those investments that match perfectly with your financial goals. You’ll learn how these investments should change as you get older, how to adjust your investor statement and stay on track.

Are You Setting Your Investments Up for Disappointment?

Few investors go as far as calculating the annual return they need to meet their investing goals. For those that put together and IPS and put in the effort to figure what kind of return they need, I’ve got a lot of respect. Most investors simply look at what stocks have done in the past and guess that they’ll get that kind of return…completely separating their investing from their goals.

But it still doesn’t go far enough.

Let’s say you work through your investor policy statement to find that you will need a 5% annual return to meet your goals. Is that realistic given your risk tolerance? Can you make more or less? How do you use that information?

What if you found the return needed was higher, say 12% over the next 20 years to meet your financial goals? What then?

The purpose of an investor policy statement is to pick the perfect portfolio just for you. That means investing the right amount in the different asset classes; stocks, bonds and real estate, depending on your needs.

We’ll get to exactly how to do that pretty soon. First, we need to talk about a harsh reality some investors may need to face.

If you find your annual return needed to meet your investing goals, based on how much you have now and how much you can put in each year, to be under 6% then you’re probably ok to skip to the next section. You might want to keep reading here because it might apply to you if your investments go off track and you find later that you need a higher percentage to meet your goals.

The problem is when investors find they need an annual return of 8% and higher to meet their goals.

Let’s look at a table of the historical returns to different asset classes over the last several years and a 20-year average. I’ve highlighted the best and worst groups in each individual year.

asset class returns for investor policy statement

A portfolio of all stocks or real estate might be able to get you that 8% or higher return over a very long period. As we’ve seen though, putting all your money in one asset class and hoping that future returns are like the past is not investing, it’s gambling.

You don’t want to gamble on something that will determine your quality of life for 30 years in retirement.

So we look instead at average returns on a portfolio including stocks, bonds and real estate. I’ve included the portfolio return for each year and the 20-year average for a few example portfolios. Each is represented by a certain percentage in each asset class, for example 80% in stocks, 10% in bonds and 10% in real estate.

Looking at it this way, we see that even this risky portfolio with almost all in stocks would just barely have reached our 8% needed over the last 20 years. Of course, we saw while putting together our investor policy statement that our risk tolerance changes as we age. While a stock-heavy portfolio might be ok for a very young investor, it is way too risky for someone closer to retirement.

But wait…it gets worse. The last 20 years through 2016 have been particularly good to investors. Sure, there have been to catastrophic stock market crashes but returns in both stocks and bonds have also been excellent as well. In fact, at the end of 2016, we find ourselves in the second longest bull market ever.

These strong stock returns and the good performance in bonds have been driven by a long trend to lower interest rates and inflation.

The cost of borrowing was nearly 6% for the U.S. government in 1996 and much higher for businesses. That rate has come down to less than 2.5% meaning that companies have had a heyday over the past two decades borrowing to grow their businesses.

Combine the potential that interest rates will most likely go up rather than down over the next decade with the fact that productivity growth (the measure of how much work a company can get out of each worker) is slowing across the globe because of an aging workforce and the next ten years of investment returns are most likely lower than history suggests.

I’ve taken a popular model for forecasting asset class returns to estimate the next ten years. Even a fairly aggressive mix of 60% stocks only gets you to about 6.5% annual return.

So what does this mean? How do you use it with your investor policy statement and to plan your investments?

It comes back to that question, “What if you find the return needed to reach your goals is high, say 8% or higher?”

This is where the harsh reality comes in. You’ve got one of three choices.

  • Take more risk than you should by putting more money in stocks, maybe even investing in penny stocks or day trading to make a higher return.
  • Lower your expectations for retirement a little. Start cutting some of the expenses from your dream retirement until the annual return you need to get there is more reasonable.
  • Figure out how to make more money now or how to contribute more to your retirement account, bringing the annual return needed down.

I hope I didn’t lose anyone after that first choice. Nobody said, “Ok, I’m going to read as much as I can about penny stocks,” right?

There’s really only two choices here. You cannot chase after more risk in your investments to get a higher return. Two stock market crashes over the past 20 years have proven it. Instead of getting that higher return, you will freak out when stocks start to wobble and will end up panic-selling.

That’s the whole point of finding your risk tolerance in the IPS, finding that level of risk you are willing and able to tolerate before losing sleep over your investments.

Without investing according to your risk tolerance, you’ll get that 2.6% annual return the average investor earned and will be forced to cut your retirement dreams anyway…and you’ll have to make much harsher cuts that you would have otherwise.

Making more money is an option as is tightening your budget a little to invest more money. This isn’t a course on how to make money but I do talk about how to budget and save in my personal finance course.

I don’t want you to think that you have to give up everything you wanted in retirement to make your return goal more reasonable. You really do need to stay under that 6% or 7% level if at all possible though.

We’re going to look at how you estimate your annual return based on how much you invest in the asset classes in the next section. We’ll come back to this idea of matching your investments to your IPS and understanding what’s reasonable and what to do in different scenarios.

How to Use an Investor Policy Statement for Worry-Free Investing

If you haven’t put together your investor policy statement yet, that’s where this is all starting so please check out the previous article here. It’s only through an IPS that you will be able to match an investing plan with YOUR needs rather than what someone on TV or the internet tells you to do.

Working through your IPS, you’ll be able to know exactly the return percentage you need to reach your retirement goals.

You’ll also find out how much investment risk you are comfortable taking before the ups-and-downs of the market start making you nauseous.

Here is where you have to do a bit of testing. I shared an easy table in the risk tolerance article (linked above) that helps you understand how much of your money should be in each asset class depending on the level of risk you’re comfortable taking.

Investment Risk Tolerance Chart

These numbers aren’t exact rules, just an example of the direction your investments should go depending on how much risk you can take. If you are not investing in alternative assets like hedge funds or startups then just shift that amount to stocks.

Next you use the long-term returns for each asset class and your percentage in each to estimate what kind of a return you can expect on your total portfolio.

how to use investor policy statement for investing

I’ve included peer lending investments as an asset class. Investing in peer loans is still a new concept but I think one of the best asset classes to round out your portfolio. I have been investing on Lending Club for years now with returns similar to stocks but risk as low as that in bonds. Check out this guide on how to start investing in peer to peer lending for monthly cash.

Again, we get to the point about comparing the return you need to meet your goals to what is possible given your mix of stocks, bonds, real estate and other asset classes. You can adjust the percentages in each investment to increase your overall return a little but don’t forget that you need to keep these percentages in a range that will keep your money safe.

If you’re not quite sure how much you should have in each asset class or just want a few suggestions, check out this six-part series on investing by age and a great infographic on how your investments change over the years.

Adjusting Your IPS for Life-Long Investing

One of the great things about following an investor policy statement, besides the fact that it customizes your investments for your needs, is that it’s a set-and-forget investment strategy. Since your investing needs and risk tolerance are long-term factors, your IPS won’t change much from year to year.

You simply set the amount you want to invest in each asset class. Invest regularly each month or quarter, splitting your money among investments in each investment type, and that’s it.

You don’t have to worry about stock market crashes, what a new President is going to mean for stocks or if you are going to meet your goals.

You’ll revisit your investor policy statement every five or ten years. That’s how infrequently it is going to change.

  1. Every five to ten years, or if you have a major life event that changes your long-term goals, you open up your IPS.
  2. Read through the statement and adjust it by updating your age, amount invested, new risk tolerance and any other part that has changed.
  3. This may give you a slightly different return needed to meet your goals and your tolerance for risk will probably have changed.
  4. Adjust the percentage you invest in each asset class according to your new return needs and risk tolerance.

And that’s it. You can wait another five or ten years and don’t need to worry about reaching your goals.

Don’t revisit your IPS if the stock market is tumbling or if you’ve just lost your job. Give it a few months or a year before making any big decisions. You don’t want your emotions getting in the way while trying to make long-term investing decisions.

Action Steps for Stress-Free Investing with an Investor Policy Statement

Working through an investor policy statement and actually using it to guide your investing strategy is a lot of work. Most investors just invest blindly for an arbitrary return without knowing how much money they need and how much risk they are comfortable taking.

If you’ve made it to this point in the article, you’ve shown that you care about getting your investments right. It’s tempting to take the easy road, throw money at stocks and hope for the best but you’ve committed to taking the time to do it right.

  • If you haven’t put together an investor policy statement, start there to learn how to make investing about YOUR needs
  • Find the level of risk you are willing and able to take along with the annual return that will help you reach your goals
  • Use this to determine how much to invest in each asset class and compare the expected return to what you need. Adjust your percentages in each asset class a little but don’t reach too far for high returns if it means taking more risk than you’re comfortable taking.
  • Revisit your IPS every five or ten years, knowing that you are on the right path and that the future is everything you want it to be!

Investing for the future doesn’t have to be a complicated strategy of stock-picking or a stressful experience of constantly guessing the direction of the economy. Use an investor policy statement to take the worry out of your long-term financial goals.

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