When it comes to investment management, it is crucial to write down your investing goals/plan in order to stay disciplined as an investor and get the returns you need with the least amount of risk possible.
The way to do this is by writing an investment policy statement.
This week, I explain about investment policy statements: what they are, why they’re important, and how to write a good one.
What you’ll learn:
- What an investment policy statement is and why it’s important to your financial future
- Why a thoughtfully written IPS will turn you into a better investor and yield higher returns
- How to write a good IPS
- The 3 crucial components all good investment policy statements have
- How often you should update your IPS
- When to reference your IPS on a day-to-day basis
If you have an IPS, what are the key sections in it? When and how often do you reference your IPS? Let me know by leaving a comment.
Don’t miss an episode, hit that subscribe button…
If you liked this episode, be sure to subscribe so you don’t miss any upcoming episodes!
I need your help, please leave a listener review 🙂
If you liked this episode, would you please leave a quick review on Apple Podcasts? It’d mean the world to me and your review also helps others find my podcast, too!
Links mentioned in this episode:
Read this episode as a post:
Today we’re going to talk about a really important aspect of investment management, something you should do at the very beginning of constructing your portfolio or working with a financial advisor, and something you should continue doing as part of your ongoing management of your portfolio over time: and that’s writing an investment policy statement.
I’m going to get into the details of what that is, why it’s important, and how to write a good one in today’s episode.
But before we jump into all that, I want to invite you, as always, to join the private Hack Your Wealth Facebook group, which you can find by going to hackyourwealth.com/fb.
It’s a private Facebook discussion group where we can connect, have a dialogue. You can ask questions about financial independence, early retirement, investing, portfolio management, tax strategies, real estate investing, side business income, or anything else related to financial planning that you’re interested in discussing.
I’m in there every day. I try to respond to every question and comment, so come check it out. Join us there: hackyourwealth.com/fb.
Before we get into the meat of it, I want to first talk a bit about what exactly an investment policy statement is, and why this topic is so important, even though it may seem obvious to some of you.
An investment policy statement is a piece of paper where you as the investor have written down what your long term investing goals are, your principles, your investing criteria, risk profile, probably your target asset allocation as well.
And it often states when, and how frequently, investments can be made in your portfolio. And it might also articulate what cannot be done with your portfolio: like what kind of risk or investments or asset allocation is not acceptable.
The purpose of an investment policy statement – or IPS – is to make clear, both to yourself and also to any stakeholders like family members or financial advisors who are involved in managing your assets, how your portfolio should best reflect your investing goals.
The reason why you should take the time to write an IPS is because investing and portfolio management is complicated. There are a lot of moving pieces.
And because it’s complicated, you want to have your investing plan, your strategy, thought through in advance and actually written down. You don’t want to just wing it day by day.
It’s no different than if you were starting a new business and writing a business plan, or remodeling a house and planning out how to sequence out all the work.
Now, it may seem like it’s a bit forced to write out what seems clear to you in your own head. And that’s especially true if you’re self-managing your investments, and you don’t have to coordinate with any family members or financial advisors.
When you don’t have to coordinate with anyone, why do you have to write stuff down? It’s already in your head, right?
And if you’re financially savvy and more knowledgeable than the majority of people when it comes to finance and tax and investment management, why go through the hassle of writing out an IPS?
Let me tell you: the best solo investors will do this.
I’ll get into how to do it in a moment. But first, I really want to hammer home the why. And there’s a couple reasons why.
First, often when you need to make big investing decisions in the moment, they typically are not when the markets are calm and peaceful. They are when there’s been a shock to the market, there’s volatility, and there’s an opportunity that has suddenly opened up that wasn’t there before.
And when that happens, you don’t have the time or luxury to ponder deep thoughts about your investing strategy at that point. You need to be able to act quickly, decisively, with conviction, because good opportunities close very quickly.
So you want to be prepared for the crucial moments when those big decisions matter. And taking the time in advance to really think through your investing plan and write it down is going to help you be a lot more clear-headed when you have to make those crucial decisions at the moment that it matters.
Because in situations like these, you do not want to be making it up on the fly. That tends to leave you susceptible to your emotions, to things like recency bias and confirmation bias, especially during periods of market volatility.
But even more importantly than that, when you actually take the time to think through the long view at a time when you’re cool-headed and things are calm, you actually will articulate and codify better investing ideas, clearer goals, and more well-reasoned investment principles.
And that directly makes your portfolio perform better, because you’ll have crisper, more confident reasons when it comes to making big investment decisions.
The second reason to write an IPS, besides being able to make big investing decisions in a well-reasoned way, is related to discipline.
When you take the time to really articulate and write down what your investing strategy is, you’re more likely to follow it with discipline. You’re more likely to reference your strategy when you make daily, weekly, monthly investing decisions.
And you’re less likely to just “go with the flow” and do what feels right “in the moment” or get sucked into investing fads.
Because your investing strategy is something that is long-term and shouldn’t change frequently, unless there are very significant changes in either your external circumstances or your personal situation.
So, taking the time to write down your investing strategy will actually give you greater discipline when it comes to investing. And just as with doing any other hard things, having discipline when you invest will deliver returns that far exceed the work it takes to define your investment policy statement.
Now, does that mean you never improvise or adapt to what the market, the broader economy, your personal situation is doing? No, of course not!
But you should still have an investing playbook, and you can adapt and adjust that playbook as you take in new information or react to what’s going on in the world. And that playbook is your IPS – your strategy.
You can be flexible on the details, but you should be stubborn on the strategy.
Of course, things are bound to not go entirely according to plan, so you will need to adapt and adjust along the way. But adjusting a well-thought, well-reasoned plan is very different than wholesale making up a strategy on the fly.
So I urge you to actually take the time to write down your investing strategy and principles.
Take the time to plan ahead and write down your strategy.
The value is in its creation. The process of thinking through the hard questions and writing them down, not the literal piece of paper itself.
So that’s a little bit about what an IPS is and why you should have one. Let’s talk a little bit about how to actually write a good one.
The key sections to have in your IPS are:
What is your long-term goal? Why are you investing this money?
As an example, that might be something like: “I am investing so that I can accomplish three goals:
I want to pay for my child’s college education which will begin around the year 2035. I want to fund a financially independent, comfortable retirement that doesn’t require significant reduction in expenses, which I expect to begin around 2045. And I want to fund a sizeable rainy day fund for medical or other emergencies that may arise along the way.”
That works. But you want it to be specific and time-bounded.
In my example, college education, comfortable retirement, medical emergencies – that’s specific.
It’s not just “because I want to maximize my portfolio.” That’s too vague.
Similarly, 2035, 2045 – there are specific milestones. That’s time-bounded, so it gives you a concrete milestone to work toward. That’s what I mean by long-term goals that you want to have in your IPS.
The second thing your IPS should have is your investing profile or risk profile.
This is about defining what your risk tolerance and return criteria are. The higher your risk tolerance, the higher your returns can be, because you can pursue higher growth stock investments. But that also means your risk of loss, your volatility risk, increase.
And vice versa: the lower your risk tolerance, the lower returns you’re going to have to expect. But also the lower risk of loss.
Given this, your IPS should specify: what is your risk tolerance?
Are you a defensive investor and want extreme capital preservation and, therefore, should be heavily invested in ultra-safe investments?
Or are you a conservative investor, and are a little bit more open to market exposure but still largely focused on capital preservation?
Are you a balanced investor, with a desire to have a mix of investment grade, blue chip investments versus some exposure to higher growth, riskier investments?
Or are you a growth investor, where you’re optimizing less for capital preservation and more for capital appreciation and, therefore, need higher exposure to growth-oriented equities?
Or are you an aggressive investor, where you’re seeking the highest returns possible, even though you know the risk of loss is also very high?
Whatever your investing profile or risk profile is, you should explicitly articulate it and write it down in your IPS. It forces you to really think about it.
And it also helps bring great clarity to the third thing that your IPS should have, which is: your target asset allocation.
Target asset allocation is really about two things: (1) What are you okay investing in, and what are you not okay investing in? (2) How much are you okay investing in each thing?
The purpose of articulating your target asset allocation here is to define what is the allocation you need to satisfy or meet your goal that you wrote in the first part of your IPS – the thing about college education, comfortable retirement, etc.?
What is the asset allocation you need to meet those goals that carries the least amount of risk?
That’s really what you’re always optimizing for: how can you exactly meet your goal, and not overshoot it, while bearing the least amount of risk possible?
Because if you have to overshoot it, that’s now a different goal, a new goal, and you’re going to have to accept higher risk to do that.
That’s why we say: what is required to just meet your goal, to just satisfy your goal, with the least amount of risk possible? That’s what you’re shooting for.
So those are the three essential sections your IPS should have: your long-term goals for why you’re investing this money, your risk profile or investing profile, and your target asset allocation – what are you investing in and how much are you investing in it?
These are the most important sections your IPS should have. It can have other things too.
It can go into a lot more detail on the three sections I’ve already outlined. But it can also go into detail on things like rules for selling, things like dollar cost averaging, specific assets or securities to buy, how to do rebalancing.
It can go as detailed as you want, or it can remain pretty broad. But the common things that all good IPSes have are the three things that I outlined: long-term goals, risk profile, and target asset allocation.
So we’ve covered the what, the why, and the how. I want to shift to a few other key topics related to IPSes that are important for you to know about to make sure your IPS remains an effective tool for managing your investments.
The first thing is: How often should your IPS be updated?
I recommend at least reviewing it annually for considering potential updates to it.
But you should also update it whenever your personal circumstances change significantly.
Maybe you make partner at your firm and your income all of a sudden jumps 8x. Maybe you get a big windfall from an inheritance.
Maybe you have a child. Maybe you suddenly get sick.
These are all examples of major personal life changes that could warrant reviewing and updating your IPS.
You might also update it if the external environment changes significantly.
Maybe there’s a big tax change that gets pushed into legislation, like the Tax Cuts and Jobs Act. Or maybe something like the coronavirus causes such large movements in the markets or changes in interest rates that it actually nudges your asset allocation decisions.
So, what I recommend is reviewing your IPS at least annually for potential updates, and more frequently if personal or external circumstances warrant it.
Now, it is also possible to update your IPS too much. How do you know how much is too much?
Well, if you’re updating it more frequently than annually or when major personal or external circumstances change, then you’re probably updating it too much.
The other extra thing I want to highlight about IPSes is, while you are probably only reviewing your IPS for potential updates once a year, or when major changes occur in your life, you should reference it before making big investment decisions, big movements of money. And that should be as frequently as required.
I’m not talking about regular periodic paycheck contributions to your 401(k) or investing a little bit of extra side money into your taxable account. I’m not talking about that.
As a mental shortcut or heuristic, what I’m talking about here is when you’re making investment decisions that might impact more than 10% of your total overall portfolio, because that is big enough to actually move the return profile of your portfolio.
If you’re going to invest or trade 10% or more of your portfolio at any one time, then it’s worth taking a quick check and reference of your IPS, just to make sure you’re not unduly violating any of the principles you previously wrote down.
Which, I might add, you wrote down when you were thinking strategically in a cool-headed way, when things were calm and rational.
Because if you’re moving 10% or more of your portfolio at a single time, then something is catalyzing that. There’s something going on in your life or in the markets to motivate that – because people don’t just do that for shit and giggles.
So, taking a quick pulse check by referencing your IPS will help you provide a natural check and balance against your impulses, to make sure that a big investment decision like that is being made in a principled way and not because you’re having a reflex reaction to something going on in the markets or in your life.
And doing this exercise doesn’t take long. Reading through and referencing your IPS takes maybe five minutes.
But that five minutes can save you a lot of heartburn, which might translate into tens or hundreds of thousands, or even millions, of dollars.
Because it serves as both a literal way to “take a deep breath and pause” – to just think before you act. But it also serves to remind you of the voice of reason you had when you wrote your IPS to begin with.
It’s just making sure that whatever is influencing your big investment decision that you’re about to make, especially if it’s the devil you know, that it gets counterbalanced by the angels of your better nature.
So that’s pretty much the long and the short of it when it comes to investment policy statements.
We talked about what they are, what purpose they serve, why they’re important, how to write a good one, what specific components or sections should be in your IPS: namely, your long-term investing goals, your risk profile, and your target asset allocation.
We also talked about additional considerations in terms of how often to update your IPS and when to reference it day to day if you’re making big investment decisions.
Hopefully, this is helpful to you as you manage your portfolio and investments, and write or update or refine your IPS.
If you have any questions about this or would like to consult with me about it, feel free to reach out via my website.
I do offer personal financial planning consultations on an hourly basis, and would be happy to help you structure and think through and develop your investment policy statement so that it’s rigorous, well-reasoned, and can serve you for years to come as you build your portfolio.
You can get more info about that at hackyourwealth.com/private-session.
Feel free to check that out. I hope that will help those of you who may still have questions about this.