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Creating Your Investment Policy Statement
Do you want to know the real secret to successful investing? It's a deceptively simple little thing called an Investment Policy Statement, or IPS. An IPS spells out an investor’s investment philosophy, asset-allocation targets, and expected results. It also lays out a plan for how the investor will monitor his or her portfolio.
Big organizations create IPSs for their company retirement plans. Financial advisors craft them for their high-net-worth clients. You need one, too. Why? Because the IPS forces you to put your investment strategy in writing and commit to a disciplined investment plan.
Here’s what you should include in your IPS, and a sample you can imitate. This is a purely a hypothetical situation and person--let's call him Chris. You need to substitute your own goals, investment-selection criteria, and expected outcomes.
Executive Summary
The important elements of your IPS--your current assets, time horizon, required return, tolerable losses, and portfolio benchmarks--appear at the start in a summary format. You’ll come back to your Executive Summary when you rebalance your portfolio.
Here is Chris’s summary.
Current Assets: Chris’s has a total of $100,000 in assets.
Time Horizon: With 20 years to retirement and an expected 34 years in retirement, Chris’s has a 50-year time horizon.
Overall Portfolio Expected Return: Chris’s expects a portfolio return that is 4.5 percentage points over inflation.
Calculating your expected return can be tricky. I suggest that you come up with a return figure in excess of inflation. Inflation will vary over time, but it’s the incremental return over inflation that's most important in meeting your goals. Don’t worry about trying to make any predictions about future inflation rates. Do think about what is reasonable to expect as an incremental return over and above inflation.
As a guideline, here are the real returns (not including inflation) that I use:
- Large-cap U.S. stocks: 5.5%
- Mid/small-cap U.S. stocks: 6.5%
- International stocks: 6.0%
- Bonds: 3.0%
If you have a balanced portfolio, you'll have a blend of these returns based on your asset allocation mix. If you are very conservative, choose numbers below our estimates. Conversely, if you are aggressive, adjust the numbers upward.
Loss Limit: Chris could accept losing 15% in any single year. Over a five-year period, he could lose 3% annualized.
This figure is the most you expect to lose over a specified time period given your tolerance for risk. So in this case, Chris knows that he could lose 15% in any one year, and he's willing to accept that level of risk. Over a five-year period, he knows that he could lose 3%. If his portfolio fell by more than that, he'd have to re-examine his securities to see how he could cut back on his riskier holdings. Investors need to balance taking on risk in order to meet their goals with taking on too much risk and losing more than they can afford to.
Asset Allocation: Chris has set the following lower limits, targets, and upper limits for investment in each asset class.
Nanci's Asset Allocation
---------------------------Lower Limit( % )------Target( % )------Upper Limit( % )
Large-cap value stocks--------15--------------------20-------------------25
Large-cap growth stocks------25--------------------30--------------------35
Mid/small-cap stocks----------15--------------------20--------------------25
International stocks-------------5--------------------10--------------------15
Bonds----------------------------10--------------------15--------------------20
Cash-------------------------------5---------------------5--------------------10
Rebalance when your portfolio exceeds the upper or lower limits.
Evaluation Benchmarks: For evaluation, Chris will compare the total return of each security to its category and expect it to be in the top 33% of its category over three and five years. He'll also ask whether he is able to reach his goals.
Even if your investments fall short of your benchmarks, you may not want to sell them if they’re still getting you to your goals. For example, take a look at T. Rowe Price Science and Technology PRSCX. In 1999, the fund returned 101% but ranked in the specialty-technology category’s 73rd percentile. If that performance is enough to get you to your goal, you may not want to sell, even if most of the category is outperforming your fund or stock. It's really a matter of judgment.
Objectives
Here’s where you state your goals. What are you trying to accomplish, and in what time frame? Seeing your objectives in writing makes a lasting impact. And it comes in handy when it's time to rebalance. If you have multiple goals, here's the place to prioritize those objectives.
Here are Chris’s objectives.
1. To retire in 20 years.
2. To be able to spend $70,000 per year, pretax, during retirement.
3. To make his assets last the rest of his lifetime.
Investment Philosophy
Jot down the basic investment theories that you believe in and plan to follow. Consider your ability to take risk, your plan to balance risk and return, and any other principles you consider important to your long-term strategy.
Here is Chris’s approach to investing.
1. Chris will balance taking as much risk as he possibly can to achieve a higher long-term rate of return with his ability to tolerate that risk and not panic in a downturn, selling at the wrong time.
2. Recognizing that he will never know which asset class will outperform each year, Chris will diversify across a wide range of investment opportunities. Then he can participate in the upside of most asset-class performance without over-concentrating in one area and risking a loss that he can't tolerate.
Preferences and Constraints
Every investor has unique circumstances that influence their investment decisions. Write down any that apply to you.
Chris’s preferences and constraints:
Time Horizon: Chris’s has a long time horizon--more than 10 years. He can afford to tolerate short-term market fluctuations.
Asset-Class Preference: Chris believes in the fundamental concept of allocating his assets over a variety of sub-asset allocation categories. His preference is to include large-cap value stocks, large-cap growth stocks, mid/small-cap stocks, international stocks, bonds, and cash. He chooses not to use emerging-markets funds or most sector funds because he thinks their risks are more than he can tolerate.
Performance Expectations: Chris's goal is to beat inflation by 4.5% on an overall basis.
Tax Issues: Chris has significant capital gains (an amount that could push his into the next highest marginal tax bracket) in his taxable accounts. To avoid an unduly high tax bill in any one year, if he decides to sell out of a significant position, he will strongly consider doing this over a period of time.
Risk Tolerance: Given that Chris has a long time horizon, he is willing to tolerate short-term market fluctuations of up to a 15% loss in any one-year. He wouldn't want to lose more than 3% over any five-year period, though. As I mentioned above in the Executive Summary, if his portfolio fell by more than that, he'd have to re-examine his securities to see how he could cut back on the riskier holdings.
Asset Allocation Limits: Every asset class has an associated level of risk and expected return. The amount of assets you put in each category depends on how much volatility you can tolerate. Chris plans to always have at least 5% in cash, but never more than 10%. He would never want to have more than 40% of his assets in mid/small-cap stocks nor more than 30% in international stocks. Further, he’d never want to have less than 40% of his assets in large-cap stocks. He would never want the combination of cash and bonds to be more than 75% of his portfolio. These limits represent how much risk Chris is willing to take with his overall portfolio.
Investment Selection Criteria
Everyone should consider how they pick their investments. There are practically an unlimited number of screens you can run with tools like Stock and Fund Selectors. Be sure to document your criteria in your IPS.
Chris's investments must meet the following criteria:
Performance Consistency: All core funds must have consistently performed in the top one third of their category for five years.
Style Purity: Foreign funds cannot have more than 10% of their assets in U.S. stocks.
The pool of funds and stocks that meet the above criteria will then be ranked highest to lowest by category rating
6. Monitoring Procedures
This section of the IPS is your blueprint of what to look at when you are rebalancing your portfolio. It forces you to think through your watch list and sell criteria.
Here are Chris’s monitoring procedures.
Although Chris will review his portfolio performance on a quarterly basis. At that time, he will not only review the returns of each of his investments against their peer groups, but he'll determine whether these investments are edging his towards his goals.
Here are the questions Chris will ask about each investment:
Has the allocation to the investment changed by more than the upper or lower boundaries outlined above? If so, consider selling some of the gains (and perhaps netting out some losses), or rebalancing within tax-deferred accounts.
Did the overall portfolio beat inflation by 4.5%? If not, what changes are necessary to meet this criteria? Are performance expectations reasonable?
Are there any changes to make due to a shortened time horizon?
Were there losses in the portfolio? Were overall portfolio losses within the loss limits specified above? If not, which individual securities were responsible for the overall losses? Has anything fundamentally changed for these securities? Do we want to make a change?
Are the securities in the top one third of their peer groups? If not, they should go on a watch list. It's not time to sell, but keep a close eye on future developments. If the security is on the watch list for more than two or three years, see if it is still meeting the long-term goals. If not, it's time to sell. (If it's in a taxable account, try to balance losses with gains.)
If a sale is contemplated, Chris will ask the following questions:
- Is the investment preventing me from achieving my goals?
- Are the tax impacts of selling outweighed by the opportunities of a new investment?
Now It's Your Turn
Use Chris's IPS as a guideline. Fill in your own expectations and criteria. Date it, sign it, and come back to it in a year. It’s the framework for analyzing your portfolio's performance--and for whether you’re progressing, as you should toward achieving your dreams.
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