For the record, this has been one of the longest running bull markets in the history of the stock market. But last month, a sudden and dramatic 1,500 point drop in one day (from the Dow’s all-time high) followed immediately by a quick rebound in the same week got everyone’s attention and rattled nerves.
We know that the best way to make money is to not lose it. When you’re wealthy, you can save yourself from making the most common and costly investing mistakes hiring an expert who manages risk by setting the boundaries for you. In fact, it’s one of the first things a competent investment advisor will do for you by drafting an explicit investment policy statement because they know it is critically important to have one.
Pension funds are arguably managing consumers’ most serious money, and they’re required to produce detailed investment policy statements that govern how those trillions of dollars in retirement money will be invested and monitored to make sure their own rules are consistent with the goals of their individual investors. Committees meet and spend hours reviewing the details of these policy statements at least once a year.
Mutual funds and big hedge funds also have to create their own guidelines, as do family offices because they know it’s an essential step in the investing process. But having an investment policy statement is not reserved for the super wealthy. Everyone who has money in the stock market should establish some basic investing ground rules and make those rules their own.
Why it has to be in writing
The purpose of an investment policy statement is to set guidelines for your investment portfolio before the stock market takes a violent, sudden turn. It’s an overarching strategy that represents your commitment, and it’s to prevent you from making emotional financial decisions that most often lead to huge financial losses. Not only is it your blueprint, but it’s also a report card or measuring stick to help you see how your strategy is working. Chances are if you’re working with a financial advisor who is a true fiduciary, he or she has already created one on your behalf or will help you craft one, but ultimately, it’s your plan. The input has to come from you. Since you’re setting your own boundaries and limitations, this statement may help you determine whether or not your advisor makes the grade. You can simply re-create your investment policy statement to assess whether your advisor’s meeting your expectations all based on, but separate from the guidelines your advisor created for your portfolio. For example, measuring the value of the guidance you’re getting compared to the fees your paying him.
It’s your personal policy statement that sets forth what you’re really trying to accomplish with your money, whether it’s to protect or grow your investments or both. It’s your goals that drive the process by which you can then review the performance of both your investments and your advisor. Your IPS should be crafted with a long time horizon in mind because it’s all about stability, so attempting to cater to short-term market panics undermines the whole purpose. Without a firmly set plan, it becomes much easier to lose our way and fall victim to such times of panic, even though on some level you know not to react to day-to-day headlines. The point is to put limits on what you’ll put up with and what investing behavior you won’t accept. Maybe you’re passionate about the future Bitcoin but not to the point where you’ll allow yourself to risk more than say, 1% of your entire life savings on crypto-currencies.
What’s in your investment policy statement?
To create an investment policy statement, you simply define your limits by stating in writing what you will and will not tolerate. Basically, you draw the lines in the sand before any investment decisions are made, and you do not cross the lines. Here are some of the most common sections of an IPS:
Basic account information – Location of assets, how much is in each account, and contribution methods.
- Objectives – Short-term and long-term goals and the time frames for achieving each one
- Asset classes to avoid and to use – Domestic or international stocks, bonds, hedge funds, mutual funds, active or passive funds, etc.
- Allocation targets – How much of your total portfolio (usually a percentage of your savings) will be allocated to each major asset class. Think: stocks, bonds, real estate and cash.
- Monitoring and controls – How often you check in and benchmarks for performance comparisons.
Most investors may be looking at this list right now and wondering how they’re supposed to come up with their own IPS. It isn’t as hard as it sounds. Start by creating a list of investment goals. For example, say you’re 45 years old with two kids. You have some money in your 401k and other savings accounts, and you’re trying to both save enough for retirement and fund two college tuitions. Those are real goals that have deadlines. Get your advisor to help you develop your guidelines based on those goals, what you have already invested, and what you can afford to contribute going forward. You’ll need a plan for meeting each of those two goals. It will move you in that direction and make you committed to saving the amount of money you’ll need to put toward each goal every year while also providing the flexibility to adjust your plan for changing your investment guidelines if your income changes.
Not having an IPS would be like taking a cross-country road trip using only unpaved roads. The stock market’s been on fire for more than eight years. This is a good time for individual investors to set their own boundaries.
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