Do you have an Investment Policy Statement (IPS)? If not, then you are missing out on one of the key ingredients of a successful investing career. An Investment Policy Statement is a written policy of your investment goals and objectives, helping you stay on track regardless of what the markets are doing. And every investor should have one – whether your just starting as an investor, or you have weathered multiple bull and bear markets.
Investing is complicated, and having a written Investment Policy Statement will save you a lot of time, money, and energy. This is nothing new. Written policies and guidelines exist in many industries. In fact, you have probably used them many times in your career.
My first exposure with using detailed written guidelines was when I worked in the US Air Force. We used Technical Orders, or T.O.s, each time we performed maintenance on an aircraft. As you can imagine, aircraft maintenance is very technical, and a lot can go wrong if you make a mistake. That is why we were required to use T.O.s when performing maintenance. Following those manuals ensured we only took prescribed methods for repairing the aircraft, and that didn’t skip any steps. This produced safer and more consistent results. I do the same thing in many areas of my life today, including running my business and managing my investment portfolio.
Let’s take a detailed look at Investment Policy Statements: What it is, why you need one, benefits, how to write your IPS, how often to monitor it, when to make changes, and much more. Buckle up, this is a 4,000 word guide that will show you everything you ned to know about writing your IPS!
Benefits of an Investment Policy Statement
There are many benefits of an IPS. Investing can be complicated, and your IPS will act as a guide to follow regardless of what is happening in the stock markets or the rest of the world. Here are some of the benefits to creating and following an IPS:
Separate Your Decision Making from Your Action Taking
As a small business owner, I create and follow business rules to make sure I stay on track. These business rules produce more consistent results with fewer resources. It makes sense when you think about it – written business rules mean you don’t have to rethink every decision.
You simply refer to the guidelines you previously created, and follow the steps you already decided you would take.
With investing, this means you don’t need to recreate the wheel each time you make a contribution to your 401k, IRA, or brokerage account. You don’t need to sit through half an hour of stock analysis of portfolio balancing before deciding to buy a stock or mutual fund. You have already made your decisions. Your IPS is there to follow.
But here is the key: You should separate these two actions. The best time to make decisions is when you have a clear mind and aren’t under any pressure. Trying to couple investment research and analysis when you are trying to make an investment decision often leads to overwhelm. Take the time to document your Investment Policy Statement and the heavy lifting is already done. You just need to take action and adjust accordingly.
Your IPS Solidifies & Defines Your Investment Goals
Writing your investment goals on paper makes them real. There is a huge difference between saying, “I want to retire someday,” and, “I want to retire at age 55.”
You will notice the first statement is a vague statement, while the other is a SMART Goal (specific, measurable, achievable, realistic, and time-based).
Your IPS will also include the types of investments you will use to reach your investment goals. This is helpful when you are thinking about investing in the next big thing – Bitcoin or other cryptocurrencies, binary options, the next big IPO, etc. Is this in your IPS? If so, then go for it, if it otherwise meets your investment objectives. Otherwise, skip it and rest in the knowledge you are investing within your defined plan.
Your IPS Removes Emotion from Investing
Investing is fun when you’re winning, and terrible when you’re losing. Unfortunately, mixing emotions and investing is never a good idea. Once you start letting emotion rule your investing decisions, you end up with clouded judgement – and a greater likelihood of losses.
Developing and using a written Investment Policy Statement will help you reduce the role that emotion plays in your investment decisions. An investment policy statement codifies your goals and strategy, offering you a plan to follow as you manage your portfolio – no matter how large it is.
Your investment policy statement can provide you with guidance, and it’s a great tool to fall back on when you start getting nervous about your portfolio.
Downsides to not using an Investment Policy Statement
Without an IPS, you are leaving your investments to conjecture. You’re basically submitting to the whims of the your emotions, and how you “feel” you should be investing. You will be more likely to chase returns, invest in the hot sectors, instead of taking action toward your goals. In short, you will be shooting from the hip instead of taking precision aim. There is a time and place for spontaneity. Investing is not that time or place.
Elements of a Strong Investment Policy Statement
An Investment Policy Statement does not have to be complicated. But it does need to have sufficient information on it to help keep your investments on track. Let’s take a look at what you need to write a good IPS:
- Investment Objectives & Investment Time Line
- Risk Tolerance
- Asset Classes to Invest in (and Which to Avoid)
- Asset Allocation Targets
- When to Rebalance Your Portfolio
- Monitoring Frequency (and When You Will Make Changes to Your IPS)
These seems like a lot, and it is. But you can simplify each of these, and in some cases, boil them down to one or two sentences. The simpler you make this, the easier it will be to review your IPS and make sure you stay on track.
Let’s take a look at these in greater detail:
Investment Objectives & Investment Timeline
The first thing you need to do as you write your investment policy statement is to identify your long-term goals. What do you want your money to accomplish on your behalf? Whether you are planning to buy a home or whether you want to save for retirement, define the goal.
As I wrote above, your Investment Objective could be as simple as, “to retire at age 55.”
Of course, most of us have more than one goal, so you can expand upon this as well. Try to prioritize your investment objectives when you write them. This will serve as a reminder to which goal is more important. In the example below, we have retirement saving listed above saving for children’s college. We all want the best for our children, but they can always borrow their way through college. You can’t borrow your way through retirement. So take this into consideration when creating your Investment Objectives.
Example Investment Objectives:
- Objective 1: Retire at age 55, or earlier
- Objective 2: Have investments support annual withdrawals of $50,000 per year, based on 4% withdrawal rate ($2,000,000 investable assets)
- Objective 3: Pay for 50% of children’s college tuition, (assuming tuition will cost $10,000 per year).
- Objective 4: Maintain 6 months living expenses in liquid funds at all times as emergency funds (assuming $5,000 per month living expenses).
As you can see, each of these objectives is listed like a SMART Goal and prioritized according to importance. (OK, maybe it’s not exactly listed like a SMART Goal, but the writer will know their own age, when their children will attend college, and the other information to fill in the gaps). They key here is to define what is important to you and list your investment objectives with specific details.
Take some time to think about your investment objectives. These online retirement planning tools may be helpful in forming a realistic retirement timeline.
Only Include Goals You Are Actively Pursuing. You can include any financial goal that is important to you, such as paying of debts, saving for a home, taking a vacation, buying into a business, or any or goal that is important to you. Just remember – this isn’t a dream sheet that lists everything you “want to do one day.” These are your actual goals you are working toward.
Now that you know what your investment goals are, you need to consider your risk tolerance. Your risk tolerance should take into account the time horizon for achieving your goal, as well as what you can financially handle. This should include your emotional risk tolerance.
Many people believe they are more risk tolerant than they really are. As I mentioned above, investing feels great while you’re ahead, but it feels even worse when you start losing money.
The key is to strike a balance between your stocks, bonds, and other securities to achieve growth, as well as have some stability.
Once you know your risk tolerance, you can use that to guide your investment choices. Stay away from investments that are too risky for your tolerance level – no matter how exciting they seem. Additionally, recognizing that you might be too averse to risk can help you create a plan that corrects this issue and helps you grow your wealth more effectively.
Your Risk Tolerance will have a direct impact on your Asset Allocation (see below for more information).
Asset Classes to Invest in (and Which to Avoid)
Asset classes are the building blocks of your investment portfolio. Asset classes can be defined as a group of securities that are similar in nature, and often have correlations in the marketplace. They are often governed by the same laws, regulations, and tax rules.
There are three main categories of asset classes, including stocks (equities), bonds (fixed income), and cash or cash equivalents. Some investors include real estate, precious metals, and commodities as asset classes.
You can further categorize asset classes based on their underlying securities. For example, you can consider US stocks and International stocks under the equities umbrella.
Here is an example of the types of investments you may wish to include in your IPS, and some you may wish to avoid. You can include specific funds if it makes things easier.
Asset Classes to Invest In:
- US Stocks (US Total Stock Market, S&P 500 index)
- International Stocks
- US Government Bonds (Treasury Bonds, TIPS)
- US Corporate Bonds
- International Bonds
- Real Estate Investment Trusts (REITS)
- All of the above should be held in low-cost in index funds, when available
Asset Classes to Avoid:
- Individual Stocks / Company Stock
- Actively Managed Mutual Funds / Hedge Funds
- Precious Metals
- FOREX (Currency Trading)
The types of asset classes you list to invest with, or avoid, can include stocks, bonds, mutual funds, ETFs, Real Estate Investment Trusts (REITS), investment real estate, precious metals, commodities, and other investments. Just make sure they meet your investment objectives.
Why this section is important: Writing down the types of investments you will use to reach your investing objectives helps keep you on track. Not sticking to your plan makes it too easy to get caught up in investment hype. There will always be hot sectors, new asset classes, and popular investments. You want to avoid trying to hit a home run with every investment. Playing the long game is the way to go. With investing, slow and steady wins the race!
Target Asset Allocation
Use your investment goals, timeline, risk tolerance, and the asset classes you defined above to create your personalized asset allocation guidelines. Your goal is to define how much of your portfolio should be in stocks, bonds, and cash.
This should be done in two steps:
- Define your asset allocation (percentage in stocks, bonds, and cash equivalents)
- Define your asset targets by type (percentage of stocks by type; percentage of bonds by type)
Step 1 – Asset allocation (percentage of stocks and bonds): This is what many people think of when they hear the words asset allocation. What percentage of your investments will be in stocks, bonds, etc.? For example, if you are young, you might want to have an 80/20 portfolio, with 80% of your investment portfolio in stocks and 20% in bonds. As you get older, you may wish to have a more conservative investment portfolio. Through the years you might transition from 80/20, to 75/25, to 70/30, to 65/35, to 60/40, etc.
Don’t know what your percentages should be? This comes back to your investment timeline (how long until you need the money) and your risk tolerance. If you still don’t know, then a good place to start is by looking at Target Date Retirement Funds, which are designed with a specific retirement date in mind. They are automatically allocated based on the target retirement date and are generally a decent reference starting point. Just use them as a starting point. You should determine your own risk tolerances.
Retirement Planning Targets by Age:
- Retirement Planning in Your 20s – Start While You are Young.
- Retirement Planning in Your 30s – Setting and Achieving Financial Goals.
- Retirement Planning in Your 40s – Making Retirement a Priority.
- Retirement Planning in Your 50s – Preparing for Life in Retirement.
- Retirement Planning in Your 60s – Maintaining Your Retirement Plan.
Step 2- Asset Targets by Type: This is where you define how much of each type of investment you have in your portfolio. You can do this by combining the Assets You Will Invest In, with your Target Asset Allocation percentage. Let’s look at an example:
Let’s say your target is an 80/20 portfolio with the assets listed in the above section. It could look something like this:
Target Asset Allocation by Type (80/20): (Note: the total percentages should equal 100%, with stocks accounting for 80% of your investment portfolio. In this example, we are treating REITS the same as stocks. You can further break down the categories into sub-categories, as shownn in this example).
- US Stocks – (45% – 30% large cap, 15% small cap)
- International Stocks – (25% – 15% developed, 10% emerging markets)
- US Government Bonds – (10% – 5% Treasuries, 5% TIPS)
- US Corporate Bonds – (5%)
- International Bonds – (5%)
- Real Estate Investment Trusts (REITS) – (10%)
- All of the above should be held in low-cost in index funds, when available
You can change these percentages to meet your risk tolerance and investment objectives as needed. For example, some investors think it’s OK to have all your equities in US-based markets, while others believe you should have some international stock exposure. Neither is technically right or wrong – only right or wrong for your asset allocation model, and thus for your IPS.
The easiest way to make sure your asset allocation is on track: Managing an investment portfolio can be tricky, especially when you have money spread throughout different investment accounts (401k, IRA, taxable investments, etc). I use a free online investment portfolio management tool called Personal Capital. Personal Capital has a free portfolio analysis tool that can securely link to your investment accounts and banks to help you understand how each of the assets in your portfolio work together. It’s an excellent tool. I use it each month when updating my net worth spreadsheet. You can sign up for a free account at the Personal Capital website.
When to Rebalance Your Investment Portfolio
Your investment portfolio will change over time. When your investment portfolio is on the small side, each contribution you make can move your assets outside their targets. Don’t worry about this too much when you are younger. Over time, your portfolio will grow and your contributions will make up a smaller percentage of your portfolio, with each contribution having a smaller impact at the time it is made (but don’t stop your contributions, compound interest is an amazing force!).
What you really want to look out for is when your investment portfolio changes due to market fluctuations. The purpose of having a mix of stocks and bonds is to decrease volatility in your investment portfolio, and smooth your investment returns. By sticking to your asset allocation, you are forcing yourself to have the discipline to sell high on investments when you go over your target allocation, and buy low when you are under your allocation.
For example, when your target stock allocation is 80/20, but a recent run up causes your allocation to trend toward 90/10, you would sell 10% of your stocks and buy an equivalent amount of bonds to bring your allocation back in line with your target allocation of 80/20.
When should you rebalance your investment portfolio? There are two schools of thought, and both work well.
- On a set schedule, such as once per year (your birthday is a good day)
- When your asset allocation exceeds a pre-determined threshold (for example, more than 5% outside if your target).
1. You can use any date for a scheduled rebalance. Many people suggest not doing it on the beginning or end of the year, because a lot of money enters the market during those times, as many people are funding IRAs or other investments. My birthday is more toward the middle of the year, so that works for me.
2. When your portfolio exceeds a pre-determined threshold. In this case, if your target allocation is 80/20, you wouldn’t rebalance your portfolio until it reaches either 85/15 or 75/25. At that time, you can make some trades to bring your portfolio back in line.
Note: Don’t forget that asset allocation can and likely should change over time. You need to shift your asset allocation as you approach your investment goal. Create a timeline for changes to your asset allocation as you progress through life. Knowing what you plan to do next will help you stick to your investment objectives and risk tolerance. It’s also a good idea to have this written down so you won’t react to the moods of the market. For example, you don’t want to ratchet up your stock allocation while things are going well (buying high), then swing the other way and change your allocation to include more bonds when the stock markets decline (selling low on stocks).
How Often Should You Monitor or Change Your IPS?
Your Investment Policy Statement should be a living, breathing policy. It should be reviewed regularly and changed if necessary. Your investment objectives will likely change as your personal and professional life changes. A lot can happen in just a few years – marriage, divorce, having children, becoming an empty-nester, getting promoted, losing a job, getting a raise, losing your job, starting a business, selling a business, relocating, winning the lottery, losing a loved one. The list is endless, and any of these can change your goals and objectives.
When to review your IPS: I recommend reviewing your IPS at least once a year, or any time you have a major life event.
You may not need to make any changes to your IPS. But regularly reviewing it will help remind you what is important to you, and why it is important to you. The why is just as important, if not more so, than the what. Regularly reviewing your IPS will also help you stay on track. This is important when things are going great and you may feel like taking on more risk, and it’s especially important when the markets tank and you may be tempted to sell low.
Just be careful not to make changes based on emotion. Consider creating a time limit before acting on any changes, such as 3 months or 6 months. That will give you additional time to reflect upon the current situation and avoid making emotional investing decisions.
Other Considerations for Your IPS
Your IPS should be tailored to your needs. You can use the information in this guide to get started. But ultimately, your IPS should reflect your investment goals, timeline, risk tolerances, and needs.
You may wish to consider other factors that may influence your personal IPS, such as:
- Any pensions or annuities, and how they might affect your risk tolerance or asset allocation
- Any life insurance policies you may have
- Social Security Retirement Benefits
- How you wish to prioritize the order of your investments – such as 401k up to company match, HSA as an Investment Vehicle, Max Out IRA, Max Out 401k, College Savings, Taxable Investments, etc.
- Where to place investments for maximum tax efficiency.
- How you will rebalance – Personally, I try to rebalance with new investment contributions when possible, otherwise, I rebalance in my tax-deferred retirement accounts to avoid taxable events and paying capital gains taxes.
- Any outstanding debt you may have
- Unusual estate planning needs
It’s important to add these additional considerations to your Investment Policy Statement so you can refer to them when you review your IPS. This will help keep your investments on track and help you avoid costly investment mistakes.
Write Your Investment Policy Statement, Review it, and Sleep Well at Night
Now it’s time to take action. Write your Investment Policy Statement and create an action plan to fulfill your IPS. Start by thinking about what’s important to you. Be prepared to go through several drafts while you determine what is most important, develop your timeline, determine your risk tolerance, and develop your target asset allocation.
Be sure you include your spouse or partner if you one. This is especially important if you are the person who normally manages all the money. You may have a higher risk tolerance than you spouse or vice versa. In general, you want to be on the same page and find some sort of middle ground. You also want your spouse to have buy-in so you will both be working toward the same financial goals.
Start Investing Now – and Follow Your IPS
Now it’s time to get started. Write a plan that sets forth how much you will invest each month, in which accounts you will invest (401k, IRA, college savings, taxable account, etc.) and which assets you will invest in.
In general, I like to prioritize my investments this way:
- 401k up to company match (Always take advantage of free money!),
- HSA as an Investment Vehicle (read why an HSA is an amazing investment vehicle),
- Max Out Traditional or Roth IRA – see where to open a Roth IRA
- Max Out 401k – even if you don’t get a company match
- College Savings – see where to open a Coverdell ESA (like an IRA for college)
- Taxable Investments – see our list of best brokerage accounts
- Long-term savings – see best online banks with high interest rates
Stick to this order of operations and you will maximize your tax deferred retirement accounts and get the greatest long-term tax benefits. You can invest with dollar cost averaging to make the most of your monthly contributions. Divide up your monthly contribution according to your stated asset allocation strategy.
How much you contribute each month should be based on your risk tolerance, as well as on your stated goals.
If you write your Investment Policy Statement correctly, it should be a somewhat succinct statement that guides you through your goals and risk tolerance, then helps you pick an asset allocation, and then lays out your ultimate plan for investing. While this guide to writing an Investment Policy Statement is several thousand words long, you should be able to keep your actual IPS to a single page.
Keep your investment policy statement somewhere you can access it easily and review your policy statement before you make any decision about your portfolio.
Looking for more inspiration? I recommend visiting the Bogleheads forum and wiki for more info on writing your IPS. I found it helpful when I created mine. Their website includes several examples and a forum where people discuss their IPS, why they make certain decisions when writing their IPS, and a lot more discussion on investing and other topics. This is my favorite financial forum, by far.
Are you ready to write your investment policy statement? Roughly, what will it look like? Leave a comment!