What is an Investment Policy Statement and Why Does Everyone Need One?
In talking with "financial advisors" or perhaps in doing your own research, you may have come across the term "Investment Policy Statement". Let's break down what that means, why it's important, and why every investor (big or small, advisor or no advisor) should have one.
What is an Investment Policy Statement?
An Investment Policy Statement (also referred to as an “IPS”) is essentially a formal document that clearly defines your investment objectives, strategy, and guidelines. It is your personal roadmap to "investing". The beauty about having something like this for yourself, whether or not your working with an advisor, is that it takes the guesswork out of your investment decisions. It gives you a plan to follow based on your unique goals and circumstances. As the saying goes, "A goal without a plan is just a wish." and when it comes to money management, I think we all want something more promising than a mere "wish". Having a documented plan will exponentially increase your probability of success.
What should my Investment Policy Statement contain?
Goals & Objectives
Like with any map, it doesn't serve a purpose unless you know where you're going. This is a commonly foregone aspect of investing. People get excited about the idea of double-digit returns without taking the time to truly reflect on "What is the purpose of this money?"
Will it be used to fund my retirement expenses?
Will it be used to fund a business startup?
Will it be used to fund my child's education?
Will it be used for a down-payment on a new home next year?
Will it be passed down to my children & grandchildren after I pass away?
This list could go on and on…and it's entirely dependent on your life goals & objectives. An investment plan cannot be constructed without knowing how the money will be utilized in the future. So in developing your own Investment Policy Statement, start with asking yourself "What is this money for?"
Investment Strategy/Philosophy
Similar to the above example, it’s important to understand your Investment Strategy & Philosophy. I won't spend the time here to get into it, but we practice an evidence-based investment philosophy at Luminary Wealth. Our understanding of the market is based on decades of peer-reviewed, scientific studies. You can learn more here if you're interested.
But regardless of whether or not your ascribe to that investment philosophy, it is important to document whatever investment philosophy you do ascribe to. Get it down on paper and follow it, otherwise, your investment decisions are likely to be based on emotions (as opposed to evidence), and that is often a losing game.
Risk Assessment
When people say “risk tolerance”, they generally think about how much loss they can afford to take in their investment portfolio, or how much they can stomach to lose without feeling the need to get out of the market completely. While that's part of it, determining your risk tolerance is a lot more than figuring out what you can handle behaviorally.
When you're determining your own personal risk tolerance, which ultimately determines your “asset allocation” (that balance between stocks and bonds), there are three things that you should consider.
Need to take risk
Ability to take risk
Willingness to take risk
I've written about this in much more detail here: https://www.luminarywealth.com/bloglist/risktolerance
Target Asset Allocation
As mentioned above, your Risk profile determines your Target Asset Allocation. This is how much you plan to be invested in various "asset classes" such as Equities (stocks), Fixed Income (bonds), and Alternatives (real estate, commodities, etc.). Ideally, you break this down even further by targeting "sub-asset classes" like U.S. vs. International Equities, Large Cap vs. Small Cap Equities, Emerging Market Equities, Bonds vs. TIPS, etc. How you decide to allocate between these sub-asset classes is entirely dependent on your objectives and risk profile.
This is a critically important component of your Investment Policy Statement because it truly is your portfolio "target"; it is the portfolio that (if properly constructed) is most likely to help you achieve your goals. If the Investment Policy Statement is the map, the Target Asset Allocation is the street names on your way to your destination.
Rebalancing Guidelines
Your Target Asset Allocation is only useful if you actually stick to it, which is why it's important to set Rebalancing Guidelines. These are tolerance thresholds that tells you when you're out of target and need to rebalance (i.e. buy or sell to bring your portfolio back to target).
So let's take a very simplified example: Assume your overall target asset allocation is 70% Equity / 30% Fixed Income. As your Equities increase in value, relative to your Fixed Income holdings, after 1 year you may now be at 75% Equity / 25% Fixed Income. If you set a 5% "tolerance" threshold for major asset classes, this would mean that it's time to rebalance. Essentially, that means you need to sell 5% of your Equity portfolio and reinvest in your Fixed Income portfolio, to bring you back to target.
One of the brilliant things about this method is that it forces you sell high and buy low in a strategic manner, rather than making trades based on emotion (which typically results in buying high and selling low); it takes the guesswork out of when you should buy and sell. If the Target Asset Allocations are the street names, then the Rebalancing Guidelines are the turn-by-turn directions.
There are several other aspects that you could include in your Investment Policy Statement, such as Asset Location, Portfolio Monitoring Procedures, Financial Advisor Duties & Responsibilities (if working with advisor), Etc. But the sections mentioned above are at the core of an IPS.
Why Do I Need One?
I think one of the best arguments for having an IPS is the ability to make investment decisions based on evidence, instead of emotion. Like I said above, it takes guessing out of when you should buy and sell. It provides you clear guidance on making investment decisions around a specific goal, regardless of market conditions. I believe it really is one of the biggest ways to reduce stress in times of market volatility. But if nothing else, it is simply a way to capture your financials goals and a strategy to get you there. You probably write down your career goals or fitness goals, so why not write down your financial goals?
It's also worth noting that this should be reviewed at least annually, or in concurrence with big life changes. Your investment philosophy shouldn't be changing annually, but your goals and therefore target asset allocation may change as life changes. So even if you're not working with an advisor, I think this can drastically improve your probability of success in reaching your financial goals.
I'm not able to share our IPS template, but if you have any questions, I'm happy to walk you through our process. Hope this was helpful!