How to Protect Yourself from Your Worst Risk: Yourself
Introduction: Why You Need an IPS
We face a fundamental paradox of investing: the expected return is positive, but it requires assuming counter-intuitive attitudes and maintaining them consistently over time. This is difficult because we live in a constant “inner tragedy” between two parts of ourselves.
The duality of the investor: Our rational and long-term perspective knows what should be done. Our emotional and short-term instinct wants to do the opposite.
In finance, the best investment decisions almost always require listening to slow, rational thinking and ignoring the suggestions of fast, emotional thinking. But the problem is that the long term is an abstraction, while we live in the present.
The IPS as a solution: an inviolable pact that transforms your rational self into a sort of “constitutional guard” of the portfolio, creating a decision-making process that is bomb-proof.
The Three Principal Risks of the Investor
Risk 1: Uncontrolled Enthusiasm
When the market rises relentlessly, the perception of risk diminishes and risk appetite increases. The average investor begins to think that investing is not risky, but rather foolish to stay out. This inevitably leads to over-investing relative to what would be prudent.
Risk 2: Discretionary Gut Decisions
The opposite: the investor becomes impulsive and makes decisions guided by fear. “The S&P 500 is too expensive, it’s about to crash” or “It’s up 100% in three years, the run is over.” These reasonings lead to baseless choices, because in the short term past performance and future performance are generally independent.
Risk 3: The Inevitable Crash
Sooner or later the party ends, or at least takes a break. We don’t know when, but when the crash comes we discover that the portfolio we thought was perfect for us actually wasn’t.
The lesson: the IPS protects you from these three risks by creating guardrails that keep your irrational part always “on the right track.”
The Two Mental Traps: Extrapolation and Overconfidence
Extrapolation: The Weight of Recent Experience
Extrapolation is the tendency to assume that our most recent experience is a reliable guide to the future. If stocks have risen for 15 years, we think they will continue to rise. If gold has lost money, we think it will continue to lose.
The trend phenomenon: Markets tend to trend in the short term. When a stock rises, it tends to continue rising. This happens because:
- We cannot process too much information at once
- Our thinking needs time to adapt
- In the meantime it puts the “autopilot” on
This is why momentum is so pervasive: stocks that have risen most in the last 12 months tend to continue rising in the next 12 months.
The temporal paradox: In the short term, positive auto-correlation dominates (trends continue), while in the medium-long term negative auto-correlation dominates (prices regress to the mean).
When interest rates fall, bond prices rise, but future returns decline. When stock valuations increase, prices rise short-term, but expected returns decline long-term.
The logical error: Extrapolating is part of our instinct, while being contrarian is a product of reason. Momentum is a consequence of instinctive reaction, value is a product of rational interpretation.
Overconfidence: The Illusion of Control
The history of markets is a story of slow growth accompanied by progressive reductions in risk perception, punctuated by sharp crashes that amplify risk aversion.
The real problem with overconfidence is not just that it leads to sub-optimal decisions, but that it risks making us lose sight of our real capacity to assume certain risks.
If your rational part has established that the right range of stocks in your portfolio is 50-70%, you cannot say after things have gone well: “Well, we were stupid to be underinvested, let’s increase exposure.”
The dangerous metaphor: It would be like the guy jumping from the tenth floor: “Well, so far so good.” The moment immediately before a market crash is precisely an all-time high.
The Five Essential Components of an IPS
1. The Ultimate Purpose (The Mission)
First, ask yourself: Why am I investing?
It is not a trivial question. It is not enough to answer “to make money” or “because I heard it mentioned.” You must identify the true purpose, the final value that would give meaning to all other specific objectives.
Concrete example: Reaching a level of financial freedom that allows realizing certain projects and experiencing certain things without the pressure of monthly income.
Why is it important? Personal finance is not free money. It requires sacrifices to save, sacrifices to invest, sacrifices to forego certain present satisfactions for uncertain future satisfactions.
The investor’s experience passes through very different seasons. Being disciplined and consistent every single day of your life is very difficult. If you have a clear goal and preferably one shared with your family, you will be more willing to pursue it and to bear the difficulties along the way, especially in the hardest moments.
2. Psychological Risk Profile
The problem with setting your risk profile during bull markets is that we think we have a high risk tolerance. During bear markets we think the opposite. But this is the opposite attitude from what we should maintain.
The paradoxical ideal: You should be maximally risk-taking during the most difficult market phases and risk-averse when expected returns narrow.
How to set your risk profile:
Method 1: Psychological Drawdown
Imagine mentally: how would I feel if my portfolio dropped -20%? -30%? -40%? -50%?
To what extent are you able to manage this situation without panicking?
Consider historical examples. A balanced portfolio would have suffered a maximum drawdown of 35% in March 2003 over the last forty years.
Method 2: Duration of Drawdown
Perhaps even more important than depth is duration. The longest drawdown could have been nearly 7 years (August 2000 – May 2007).
Critical question: Could you stay underwater for an entire decade without deciding to exit the market and realize losses?
It depends on your personal situation. If you’re 40 years old, generating income, and have a family, 10 years of drawdown might be bearable. If you’re 5 years from retirement, probably not.
Method 3: Drawdown Plus Simultaneous Income Reduction
Do not consider drawdown in isolation. If the stock market crashes 40-50%, something serious probably happened to the real economy. Consider how you would live a scenario where portfolio drawdown coincides with a reduction in your income.
For example: portfolio -20% and income -10%, or portfolio -40% and income -20%.
This depends on your type of work and its sensitivity to economic cycles. If you work for a large consolidated company, the reduction will be minimal. If you are a freelancer or entrepreneur, it could be significant.
3. Objectives, Time Horizon and Expected Returns
Decide where your objectives fall in time and what return you need to achieve them.
Three possible scenarios:
Scenario 1 – Pure long-termist:
- Horizon: 20+ years
- I don’t intend to touch the money
- Minimum acceptable return: 7-8% annual compounded
Scenario 2 – Flexible long-termist:
- Horizon: 15-20 years
- I could touch the money with flexibility
- Minimum acceptable return: 5-6% annual compounded
Scenario 3 – Medium-termist:
- Horizon: 8-12 years
- Almost certain I will touch the money
- Minimum acceptable return: 3-4% annual compounded
Important considerations:
There is no mechanical correspondence between portfolio X and return Y. But we know that:
- To obtain very high returns (7-8% annual), the dispersion of results will be very wide
- To obtain low returns (3-4% annual), with more bonds, the dispersion will be more contained and the minimum return more likely
Plans change: Don’t forget to regularly update your IPS. Major life changes (job change, relocation, children, inheritance, health issues) may require a complete review.
4. Portfolio Management Principles
Asset Allocation
Choose between two approaches:
Static Asset Allocation:
Choose a portfolio that reflects your maximum acceptable drawdown and the best time horizon for your objectives.
Use for example Bernstein’s rule:
- Minimum between: (Max Tolerable Drawdown x 2.5) and (Time Horizon x 7)
Example 1: I tolerate max 20% drawdown, 20+ year horizon → 20 x 2.5 = 50% maximum in stocks Example 2: I tolerate max 40% drawdown, 10 year horizon → 10 x 7 = 70% in stocks
Even simpler alternative: choose a coherent “lazy portfolio” (Permanent Portfolio, All-Weather, Golden Butterfly, etc.)
Dynamic Asset Allocation:
Your asset allocation varies as a function of:
- Your overall risk profile
- Expected returns on stocks (riskiest asset class)
It is based on the idea that stock returns are not constant but vary relatively predictably through valuations.
When stocks have high prices relative to earnings → lower expected returns, lower perceived risk When stocks have low prices → higher expected returns, higher perceived risk
A simple formula: The De Bull Rule
During the accumulation phase, invest in stocks a percentage of your investable capital equal to:
125 – your age – (risk-free rate x 5)
This partially accounts for both the variation in time horizon and changes in risk premium.
Alternative Assets:
Consider whether to add a third component to your portfolio beyond stocks and bonds: gold, commodities, inflation-indexed bonds, managed futures, etc.
These assets often involve long periods of underperformance. It is essential to have a clear plan (for example: always 5-10% in gold) to maintain discipline and obtain the benefits that these assets require perhaps decades to materialize.
Accumulation Plan
Decide:
- How much to invest per month?
- Proceed with fixed amounts, percentages, or other criteria?
- What growth target do you set for yourself over time?
Do I want to reach a certain absolute value or a certain percentage of my income?
Deciding and committing to systematically increase your investment rate according to a defined criterion will make you progress in your journey. If left to chance, you will probably never maximize your saving and investing capacity.
Rebalancing
Decide your rule:
Option 1: Rebalance once a year (fixed)
Option 2: Never rebalance
Option 3: Rebalance for “tolerance bands” (drift)
- Each time an asset deviates 10-20% from target, I adjust it
The latter is the preferable strategy because:
- Rebalancing less frequently is generally better than rebalancing too often
- Never rebalancing creates significant management risks
- It forces behavior that makes sense: it limits overconfidence during positive phases (prevents you from over-investing in stocks) and counteracts the opposite excess (forces you to invest in stocks when they crash and you’re afraid)
Key point: Whatever you decide, write it down and implement it religiously, to avoid moving from one strategy to another at every minor market variation.
5. Behavioral Management Principles (The Heart of the IPS)
This is the most important section. Write down the principles you are most likely to violate during critical moments. These are the “guardrails” that will protect your portfolio from your irrationality.
Principle 1: Volatility is the Price of Admission
Stocks can easily lose more than 50%. Don’t panic. Over the next twenty years it is almost certain that money invested today will have grown, but it is equally certain that you will experience at least three or four bear markets.
Principle 2: Markets Are Smarter Than You
The market is smarter than you. Your intuitions, given that markets are more efficient than not, have no competitive advantage. Do not fool yourself into thinking you can predict market movements.
Principle 3: Don’t Judge from the Short Term
You will be tempted to judge an asset by its recent performance. But often recent performance and future performance are negatively correlated. Gold has performed poorly in recent years? That doesn’t mean it will continue to perform poorly. Stocks have gained 100% in three years? That doesn’t mean they will continue.
Principle 4: Know Your Emotional Biases
You will be more enthusiastic during bull markets and more pessimistic during bear markets. As a result, you might take more risk than you should during the first (over-investing) and not enough during the second (panic selling).
Remember: you should do the opposite.
Principle 5: Your Only Competitive Advantage
The only competitive advantage you can gain over the market average is the ability to assume more risk than average. But this requires patience, discipline, and consistency.
Not the need to do complicated, expensive, or risky things. Simply to do simple things consistently.
Principle 6: Conjugate Verbs in the Past Tense
In finance, the only acceptable verb tense is the past.
Say: “Stocks have risen” (correct) Say: “Stocks are rising” (incorrect)
Say: “Inflation has risen” (correct) Say: “Inflation is rising” (incorrect)
When you conjugate verbs in the past tense, your judgment remains neutral. When you conjugate them in the present or future, your decisions are influenced from the start by the illusion that the present will continue indefinitely.
Principle 7: Marginal Utility is Concave
The utility of money is concave, not convex. The more money you accumulate, the less additional benefit each new euro provides. So calibrate your sacrifices to maximize your marginal utility and nothing more.
The final lesson: Sacrificing your life for money is almost never worth it.
The Two Recurring Enemies: Short-Termism and Irrationality
The Two-Speed Structure of Markets
In the short term (weeks, months): your instinctive short-termism dominates. Trends continue, momentum is strong, your thinking puts itself on autopilot.
In the medium-long term (years, decades): underlying fundamentals dominate. Prices regress to the mean, expected returns are realized, fundamentals come to the fore.
The problem: We live in the present and our instinct has been designed by nature to handle short-term matters. Therefore, the first decision we would want to make is always the instinctive one. Reason needs to correct it so the decision is actually functional to our long-term objectives.
The Negative Consequences of Unmonitored Short-Termism
Consequence 1: Your portfolio becomes a random collection of instruments chasing the trend of the moment, instead of being a coherent organism with few things, each in its place, with a precise purpose.
Consequence 2: You judge the validity of an asset by its recent performance. Stocks are doing well? Let’s invest more. Bonds are performing poorly? Why did I put them in? But there will always be elements of your portfolio that are disappointing you. They are there for a reason. It is not possible to always have only the right assets at the right time. You need a portfolio that reacts well in different situations. As often said: not diversifying means having some regrets. Diversifying means always having regrets.
Consequence 3: You overestimate or underestimate how much risk you want, can, and should take. If you take too much risk, you have problems achieving your objectives. If you take too little, you leave return on the table.
How to Write Your IPS: The Practical Guide
Step 1: Fill in the Purpose Section
Answer in writing: Why am I investing? What is my final vision? What will this wealth allow me to do?
It doesn’t need to be very long. It needs to be authentic and meaningful to you.
Step 2: Determine Your Risk Profile
Mental exercise: How much drawdown can I tolerate? For how long?
Write your maximum acceptable drawdown and the maximum duration you can bear.
Consider a scenario with drawdown plus simultaneous income reduction.
Step 3: Define Your Objectives and Time Horizon
List of principal objectives (home purchase, retirement, projects, etc.) When do you need this money? What minimum return do you need?
Step 4: Choose Your Asset Allocation
Static or dynamic?
Percentages of stocks, bonds, alternative assets.
If you use a formula (Bernstein, De Bull, etc.), document it.
Step 5: Define Your Accumulation Plan
How much do you invest per month? According to what criterion (fixed amounts, percentages, other)? How do you intend to increase over time?
Step 6: Decide Your Rebalancing Strategy
Once a year? For tolerance bands? Never?
Write your rule exactly.
Step 7: Write Your Behavioral Principles
This is the most important section. Don’t copy. Think about which decisions you are most likely to make incorrectly and protect yourself from these.
Examples:
- If I want to add cryptocurrencies to my portfolio, I ask myself if it was already in my plan
- If I want to sell everything in panic, I reread this section
- If I feel too confident and want to add leverage, I remember my maximum tolerable losses
Step 8: Sign and Preserve
Sign your IPS. Date it.
Keep it in a safe place.
Reread it every time you’re about to make an important financial decision.
When to Update Your IPS
The IPS is not fixed forever, but it is conservative. Update only when:
- Major changes in your life (work, family, inheritance, health)
- At least once a year for general verification
- Your time horizon remains coherent
Do not update in reaction to the market. If the market crashes, do not change your risk profile. In fact, it might be the time to maintain discipline.
Conclusion: The IPS as Insurance for Financial Sanity
The Investment Policy Statement is insurance for your financial sanity. It allows you to always have your rational and long-term conscience by your side, with which to compare all the decisions you will make in the short term.
If the decision you are about to make is compatible with the principles of your IPS, you can make it with serenity, without regrets or remorse.
If the decision is not compatible with the principles of your IPS, simply do not make it.
Writing a well-done IPS could be the most profitable hour of your entire life.
Because it transforms decision-making from emotional and random to rational and structured. And in finance, as in many other areas of life, it is discipline, not intelligence or luck, that makes the difference in the long run.
Do not forget these words at the moment you are most tempted not to respect your IPS. Right at that moment, respecting it will be the most important thing of all.
