Part of a solid foundation to financial freedom is protecting yourself and your family. That means protecting your property through insurance; your health, life, and ability to earn income; and your identity. But it also means protecting yourself from financial mistakes, and the best way to do that is through the use of an investment policy statement and solid financial plan. Today I’ll talk about the investment policy statement and how it can help you protect against the biggest issue keeping you from excellent investment returns-your own behavior. But what are investment policy statements for, how do you create one? Lets break this down – and I’ve included an example and a template for you to use!

 

Investment Policy Statement – How To

I was first introduced to this concept over at Bogleheads, and I think it’s a great one.  Are you interested in achieving excellent long-term investment performance? Willing to put in a few hours of research to determine what the content should be? Then this is right up your ally.

This is something that you create once, and revisit every year or so to update your financial information. It consists of several parts:

Financial Account Information

This section is a simple statement of what you have. You could also write “see net worth statement” in this section, if you keep a separate document outlining your net worth. You’ll want to list what accounts you have, what’s in each of them, and your contribution plan for the year for each account. This section is updated yearly.

Investment Objectives

The investment objectives section details what you want in your financial life. This includes both short- and long-term goals, and could include things like funding college, buying a house, paying off a mortgage, or retiring. You’ll want to list:

• Time Horizon for each objective
• Risk tolerance for each objective

Asset Classes 

This is where you outline, for each objective, what asset classes you will use. Asset classes are categories of assets – equities (stocks, international stocks), fixed income (like bonds), and cash. You may include real estate, commodities, and cryptocurrency here too.  Don’t look at what you have invested in right now for this section-research what you should ideally have.

If there’s a mismatch between the ideal and what you have in place, you can fix it later. Don’t let analysis paralysis hold you back!

In order to figure out what assets classes you want to use, you’ll need to do some research on the types of assets available, and your risk tolerance. Most of the time, you will want to have some combination of the major three asset classes of equities, fixed income, and cash. In this part of the process, you’ll want to assess whether you want to invest in – or avoid – certain asset classes.

Be sure to list both what you’ll invest in, as well as what you want to avoid. This can help you later, if you see a “hot tip” for a kind of investment that you don’t have the risk tolerance for (cough Bitcoin cough).

Asset Class Research Resources:

Asset Class Definition from Investopedia

Overview of Major Asset Classes and How To Invest In Them from Nerdwallet

Asset Allocations

Asset allocation is the process of deciding how much of your money will go into each asset class. If you’re new to investing, this can feel overwhelming. After all, there’s so much different advice out there about the “ideal” portfolio, that none of the experts seem to agree with each other.

You’ll find that’s true of most things investing. You can find one source that tells you this strategy is the one that will win – and a minute later, find a contradictory source. Part of becoming a successful investor is learning to ignore the noise and do the best you can.

I prefer investing in passively managed index funds. So few actively managed funds beat the market, that it’s better to be the market. This of course is not the only way to manage your money. I encourage you to do your own research.

Your risk tolerance plays a key role in deciding how much of your money to put in each asset class. Equities will provide a higher return over time, but are much more volatile. Small companies are riskier than large ones. Bonds provide a more stable rate of return, but in times of rising interest rates bond funds may not be a wise choice. Your risk tolerance is usually a combination of how much risk you’re willing to take, as well as how much risk you’re able to take. Factors to consider include your age, family situation, and employment situation.

Resources:

Asset Allocation Definition from Investopedia

Determining Your Asset Risk Tolerance from Vanguard

SEC Beginners Guide to Asset Allocation, Diversification, and Rebalancing

Asset Allocation from Bogleheads Wiki

Rebalancing

What exactly is rebalancing? Well, over the year your various investments will go up and down in value. When that happens, you may want to bring your investment allocations back in line with your ideal.

Do you need to rebalance? There’s a debate in the financial community as to whether or not it’s helpful. Personally, I choose to rebalance once per year. Some folks choose to rebalance under specific circumstances.

You’ll want to write down your rebalancing criteria. Whether it’s a percentage range (e.g., I will rebalance when my asset allocation is more than 5% over/under from my target) or a timeframe (e.g.,  every year on December 1st.). The key here is to be specific and stick to it.

Rebalancing Resources:

Rebalancing Definition from Investopedia

Best Practices for Portfolio Rebalancing from Vanguard

Is Rebalancing Really Necessary? From US News

Rebalancing Overview from Bogleheads Wiki

Monitoring and Control

Once you’ve decided on your strategy, it’s time to make sure you stick to itDetermine how often you’ll monitor to see if you’re on track – monthly, quarterly (like me!) or annually. In terms of control, this is where the rubber meets the road-when can you change your IPS?  List specific financial reasons and life reasons. Then list reasons you cannot change your IPS-including market drops. This is here to make sure you don’t get scared and sell at the bottom when the market has a correction

The goal here is to create a one-page simple summary of your investment objectives and strategy. There’s no need to get complicated (although you can if you want to) – in fact you’ll want it to be straightforward enough that a non-investor can understand it.

Example Investment Policy Statement

Section	Example Contents
Financial Account Information	Currently have: - $X in pre-tax retirement accounts - $Y in post-tax retirement accounts - $Z in post-tax investments - $M in college savings - $N in emergency funds. See quarterly Net Worth statement for details
Investment Objectives	My objectives are: -To pay for college for my three children starting in 5, 9, and 17 years respectively -Pay off my mortgage by the time I'm 40 -To fully fund retirement starting at 55
Target Assets and Allocations	My target allocations are: 6 months in emergency cashFor other investments: -US Total Stock Market - 55% -International Stock - 25% -US Bond - 15% -International Bond - 5%. I will avoid actively managed funds wherever possible, and risky investments.
Rebalancing	I will rebalance annually on December 31st, reducing stock investments by 2% and increasing bond investments by 2% every five years
Monitoring	I will monitor my investments quarterly and report on them to my family annually
Control	I will only alter this investment policy statement in the case of a catastrophic life event, such as death or disability. I will not alter it as a result of market declines in either stocks or bonds, or based on what the financial "experts" say.

If you would like to know more, the Bogleheads page has some good Investment Policy Statement examples. Also, Big Law Investor ran a good article on Investment Policy Statements that you should read if you want to learn more.

Investment Policy Statement Template

I’ve created a handy template you can print to create your own investment policy statement. Simply click on this link to access the investment policy statement template, print, and complete.

Want to save this for later, to remind yourself to create your IPS? Bookmark this page.

Why Is an Investment Policy Statement Important?

If you’re wondering why this is important, just take a look at the Dalbar studies on investor behavior. Over the last 30 years, the S&P 500 has returned slightly over 10%. So the average investor has done well, right? Well, unfortunately, no.

The average equity investor has received returns of only 3.66%. In the year ending 2015, the market returned 1.38% but the average investor managed to lose money (2.28% to be exact). Behavior is the biggest performance drag of all.

What kind of effect would this have on your investments? Lets take two investors, Sally and Jane. They both started investing 30 years ago at the age of 30 with $10,000, and deposited $100 per month. They’re now both 60 years old and want to retire.

Jane decided to just invest in this new thing called a Vanguard index fund, and never deviated. On Black Monday in 1987, the tech crash of the early 2000’s, and the Great Recession, she never changed. So she’s achieved the S&P 500 average return.

Sally, on the other hand, got in and out of the market. She invested in the latest funds touted by Kiplingers and Money Magazine as the best places to be. She got heavy into tech stocks just before the crash (because all her neighbors were making bank!) and when burned on those, decided real estate was a safer place to be (because of all those HGTV shows about house flipping!). Over the years her “hot funds” cooled off, and she jumped into the next big thing. So she’s achieved the average investor return over time.

When they get together to talk about their retirement (according to this calculator), Sally is not feeling so hot. She has just under $100k in her investment account – $95,488 to be exact. Although it’s certainly better than nothing, she’s going to have to live off this plus social security for the next 20-30 years. A 4% withdrawal rate means she can only withdraw $3,819 per year.

Jane is feeling much better about her retirement prospects. She has $469,943 in her accounts – over four times as much as Sally! Her safe withdrawal rate is similarly much higher, at $18,797. Now this might sound low, but combined with social security and a paid off house, is plenty to life off of for the next 20-30 years in most areas of the country.

Remember, both these women invested nothing except $100 every month-never increasing it for raises or inflation over the years. That’s unlikely-hopefully over time they would have been able to contribute much more even by simply raising their contributions a few percentage points each year.

Interestingly, the people who’ve performed best in their accounts are the people who forgot they had accounts and just left their investments alone. Your behavior is just about the biggest performance drag you’ll find. That’s where the Investment Policy Statement helps you. You create it logically, based off research on the best way to invest. Then when an event comes up where you’re tempted to buy or sell, you re-read your statement to make sure it’s in alignment.

Do you have an investment policy statement, or are you planning to make one? What do you think the key points to include would be? Let me know in the comments.

Check out more about investments and taxes here:

Investing and Taxes

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