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In creating an Investment Policy Statement (IPS), you need to conduct a comprehensive investor profile. Who you are as an investor and what you want to achieve.

Part of this requires assessing your current financial situation, as well as investment related objectives and constraints.

But it is also important to factor into your analysis three key variables. These are: investment time horizon; current phase of life-cycle; risk tolerance level.

Let us take a look at these crucial areas .

Time Horizon

We reviewed time as it relates to investing in our compound return discussion.

Longer Time Frame, Greater the Risk and Return

The longer the investment time frame, the greater the potential volatility (i.e. investment risk) that can be accepted in a specific asset.

And from the relationship between risk and returns we saw that the more volatility that an asset has, the higher the expected return that should be associated with the investment.

If your objectives are far in the future, you can afford to take on additional risk in the expectation of higher returns. This is because you can ride out the up and down swings over long periods and average out the higher expected return over time.

If you have near-term goals, then you want increased certainty as to the result. You do not want to be caught in a down swing during the initial period when you require the funds. So you willingly accept higher certainty in a lower return investment as an acceptable trade-off.

This is why it is commonly recommended that younger investors invest in higher proportions of equities than in fixed income or cash. And for seniors that require a consistent and constant cash flow to finance their retirements, it is usually recommended that they have most of their assets in fixed income or cash instruments.

Longer Time Frame, Less Capital Needed

The longer you have to invest, the less you need to invest.

Both on a periodic basis, as well as in total.

For example, a 25 year old with a 40 year investment horizon only needs to contribute $315 per month at 10% to accumulate $2 million at age 65. If that same person delays investing until 30, he will need to invest $525 per month at the same 10% return. Wait until age 40 to start investing and he will need to contribute $1500 per month at 10%.

A significant difference in money needed to fund the account each month.

The earlier one starts to invest, the less of a problem it is to find the necessary cash.

As a further incentive to start investing, look at the actual aggregate contributions made by individuals at each age. The 25 year old contributes $151,200 over 40 years to amass $2 million. The 40 year old has to contribute $450,000 over 25 years to accumulate the same $2 million. Again, the power of compounding has a tremendous impact on wealth accumulation.

Fortunately, many people reading this post are relatively young. That means time is less of a potential constraint. It also means that with compound returns, by starting to invest now you will need to find less cash monthly, and in aggregate, to accumulate wealth over the long-term.

Phase of Life-Cycle

We have also previously reviewed the life-cycle view of wealth accumulation.

Usually Correlated to Age

The phase in one’s life-cycle is normally linked to age.

When you are young, you are just starting out in the world. Income is relatively low, costs are high. As you get older you begin to accumulate wealth, but costs are still high. As income continues to rise and costs begin to fall (mortgage paid off, no car loans, etc.), wealth accumulation takes off. Then you retire and income falls, requiring the use of savings to make up the shortfall between income and costs.

But Not Always

While this may still be normal for most people, times have changed somewhat.

Increased unemployment may alter one’s progression through income increases over time. More individuals are becoming entrepreneurs which also impacts the normal progression between life and income.

As well, people are getting married later in life and having fewer children. Interest rates on debt are relatively low. Housing prices in many areas are extremely depressed. So there may be less costs for younger adults than in previous decades.

And these are just a few quick examples as to how things are changing.

Do not simply assume your investment time horizon and life-cycle phase are connected.

Look at both areas separately when assessing your investment objectives and constraints.

Risk Tolerance

Risk tolerance is another area we have previously reviewed.

The greater one’s risk tolerance, the greater the potential for higher expected returns over extended time periods.

That is not to say, head to Las Vegas and “invest” your money in the casinos. But I am saying that a properly structured investment portfolio should achieve higher expected returns over the long run than the same money being invested in Treasury bills or term deposits.

I understand though that risk tolerance differs from investor to investor. If you are more comfortable in lower risk assets, that is fine. Just realize that you may need to invest more, for longer periods, to achieve your goals.

In our example above, you can see the potential results from investing in a safer portfolio with lower expected returns.

Investor Profile Drives the Actual Investing Process

An investor’s objectives, constraints, investment time horizon, phase of the life-cycle, and risk tolerance define an individual’s investor profile.

It is important that you clearly understand your own profile. If you do, I think you will make smarter investment choices when managing your own wealth.

It is also imperative that any financial advisor who manages your money also clearly understands your profile. That is why it needs to be discussed and agreed upon in writing, so as to eliminate as much ambiguity as possible.

Your profile will serve to drive the rest of the investment process.

What asset classes you include or exclude. The asset allocation that you choose. The investment styles, strategies, and tactics that you use. So the investor profile is crucial if you want success in your investment plans.

Next, we will start a look at asset allocation.

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