Creating an Investment Policy Statement: A Guide to Long-Term Financial Success

Imagine setting sail on a long voyage without a map or a compass. You might drift aimlessly, tossed about by unpredictable currents, and end up far from your intended destination. Investing without a clear plan is much the same. That's where an Investment Policy Statement (IPS) comes in – a crucial document that acts as your financial roadmap, keeping you focused and disciplined on your journey toward achieving your financial goals.

What is an Investment Policy Statement (IPS)?

An Investment Policy Statement is a written document that outlines your investment goals, risk tolerance, time horizon, and specific guidelines for managing your investment portfolio. Think of it as a contract you make with yourself (or your financial advisor) to ensure your investment decisions align with your overall financial objectives. It's a living document, not set in stone, but provides a framework to guide you through market ups and downs, preventing emotional decisions that can derail your long-term plans.

Why Do You Need an IPS?

Creating an IPS offers numerous benefits for both novice and experienced investors:

• Provides Clarity: It forces you to clearly define your financial goals, such as retirement, buying a home, or funding your children's education.
• Manages Risk: An IPS helps you assess your comfort level with risk and build a portfolio that matches your tolerance.
• Promotes Discipline: It prevents impulsive decisions based on market hype or fear. When the market gets volatile, you can refer back to your IPS to remind yourself of your long-term strategy.
• Enhances Communication: If you work with a financial advisor, an IPS ensures everyone is on the same page regarding your investment objectives and how they will be achieved.
• Benchmarks Performance: It provides a framework for evaluating the performance of your investments against specific goals.
• Reduces Emotional Investing: By having a pre-defined strategy, you're less likely to make rash decisions based on fear or greed, which can significantly impact your returns.

Key Components of an Investment Policy Statement

A comprehensive IPS typically includes the following essential elements:

1. Introduction and Purpose

This section outlines the purpose of the IPS and identifies the parties involved (e.g., the investor and their financial advisor). It should also state the scope of the document and the assets it covers.

2. Client Profile

This is a detailed overview of your current financial situation, including:

• Financial Goals: Specific, measurable, achievable, relevant, and time-bound (SMART) goals, like Retire at age 65 with an annual income of $80,000.
• Time Horizon: The length of time you have to achieve your goals. A longer time horizon generally allows for more aggressive investment strategies.
• Risk Tolerance: Your ability and willingness to accept potential losses in exchange for higher returns. This can be assessed through questionnaires and discussions.
• Current Financial Situation: A summary of your assets, liabilities, income, and expenses.
• Tax Situation: How taxes will impact your investment decisions.
• Unique Circumstances: Any factors that might influence your investment strategy, such as upcoming large expenses or inheritance expectations.

3. Investment Objectives

This section translates your financial goals into specific investment objectives, typically expressed in terms of:

• Return Requirement: The rate of return you need to achieve your goals. This should be realistic and consider inflation.
• Risk Tolerance: A restatement of your risk tolerance, perhaps with more specific guidance on the types of investments you are comfortable with.

4. Investment Guidelines

Here's where you define the rules and constraints for managing your portfolio:

• Asset Allocation: The percentage of your portfolio allocated to different asset classes, such as stocks, bonds, and real estate. This is arguably the most important decision in investing.
• Diversification: Guidelines for diversifying your investments within each asset class to reduce risk.
• Investment Selection: Criteria for selecting specific investments, such as mutual funds, ETFs, or individual securities.
• Prohibited Investments: Any types of investments you want to avoid.
• Socially Responsible Investing (SRI) Considerations: If you want your investments to align with your values, specify the criteria for SRI.

5. Performance Measurement and Reporting

This section details how your portfolio's performance will be measured and how often you will receive reports.

• Benchmarks: The specific market indexes (e.g., S&P 500, Bloomberg Barclays Aggregate Bond Index) that will be used to compare your portfolio's performance.
• Reporting Frequency: How often you will receive reports on your portfolio's performance (e.g., quarterly, annually).
• Performance Metrics: The specific metrics that will be used to evaluate performance (e.g., total return, risk-adjusted return).

6. Duties and Responsibilities

This section outlines the responsibilities of each party involved, including the investor and their financial advisor (if applicable). It should clearly define who is responsible for making investment decisions, monitoring performance, and updating the IPS.

7. IPS Review and Modification

Your IPS should be reviewed and updated regularly, especially when there are significant changes in your life or financial situation. This section specifies how often the IPS will be reviewed and the process for making modifications.

Steps to Creating Your Investment Policy Statement

Creating an IPS might seem daunting, but breaking it down into manageable steps makes the process easier:

1. Define Your Goals: Clearly articulate your financial goals, making them as specific as possible.
2. Assess Your Risk Tolerance: Honestly evaluate your ability and willingness to take risk. Consider your time horizon, financial situation, and personal comfort level.
3. Determine Your Time Horizon: Estimate the length of time you have to achieve your goals.
4. Determine Your Asset Allocation: Based on your goals, risk tolerance, and time horizon, decide how to allocate your portfolio among different asset classes. You can use online tools or consult with a financial advisor to help with this.
5. Document Your IPS: Write down all the elements discussed above in a clear and concise document. There are also readily available templates online that can help you structure the document.
6. Review and Revise: Regularly review your IPS to ensure it still aligns with your goals and circumstances. Make necessary adjustments as your life changes.

Example of a Simplified IPS

To illustrate, here's a simplified example of an IPS for a hypothetical individual:

Client: Jane Doe

Goal: Retire at age 65 with an annual income of $60,000 (in today’s dollars).

Time Horizon: 25 years

Risk Tolerance: Moderate

Asset Allocation:

• Stocks: 60%
• Bonds: 30%
• Real Estate: 10%

Benchmark: 60% S&P 500, 30% Bloomberg Barclays Aggregate Bond Index, 10% MSCI US REIT Index

Review Frequency: Annually

Common Mistakes to Avoid

Creating a strong IPS is important, but it’s also important to avoid some common pitfalls. Here are some mistakes to avoid:

• Being Too Vague: Generalities like save for retirement aren't helpful. Be specific about the amount you need and when you need it.
• Ignoring Risk Tolerance: Overestimating or underestimating your risk tolerance can lead to inappropriate investment decisions.
• Setting Unrealistic Expectations: Don't expect to achieve extremely high returns without taking on excessive risk.
• Not Reviewing Regularly: Failing to review and update your IPS can render it obsolete.
• Failing to stay disciplined: You may have the best IPS but if you do not stick to it you will not achieve your desired goals.

The Role of a Financial Advisor

While you can create an IPS on your own, a financial advisor can provide valuable assistance:

• Objective Assessment: An advisor can provide an unbiased assessment of your financial situation and risk tolerance.
• Expert Guidance: They can help you develop a realistic investment strategy and select appropriate investments.
• Ongoing Support: An advisor can monitor your portfolio, provide regular reports, and help you make adjustments as needed.

If you decide to work with one, it’s always best to do your research and select a registered investment advisor. You can learn more about advisors registered with the Securities and Exchange Commission on the SEC website. You can check investment advisor registration here.

Conclusion

Creating an Investment Policy Statement is a vital step toward achieving your long-term financial goals. It provides a clear roadmap, promotes discipline, and helps you manage risk effectively. Whether you're a seasoned investor or just starting out, taking the time to develop a comprehensive IPS will significantly increase your chances of success. Don't set sail without a map – create your IPS and navigate your way to a secure financial future.