investment policy statement

Investment Policy Statement – A Key Part of Your Financial Plan

The investment policy statement can be a very useful guide in helping you to implement your financial plan. By writing down your goals, preferences, and overall investment strategy, it will make it easier to clarify your intentions and promote discipline to stay the course.

Emotional biases, market volatility, and otherwise tough times can make it tempting to go astray. The result can be irrational decisions and abandonment of your initial plan of how you will invest your money. If you work with an investment advisor, the investment policy statement can also help avoid misunderstandings.

This is not to say that a change in your personal circumstances should not warrant a review of your policy statement. But creating a written document of your investment plan and process will provide stability and focus. It will also make it more likely that you will set realistic goals.

You will indicate the approximate rate of return you expect to earn for each of your goals, while maintaining a risk level you are both able and willing to accept. Your return and especially your risk will in turn be dependent on your ability and willingness to take risk.

Identify Your Goals

First you must identify your goals. For example, you may decide that you need to accumulate $800,000 over thirty years so that you can retire comfortably. You may also wish to save $60,000 within ten years in order to make a down payment on a vacation home.

You should also indicate how far along you may be in achieving each goal. So in the retirement goal example above, you might already have accumulated $200,000 in your retirement accounts. In that case, you would need to accumulate an additional $600,000 to meet your stated goal.

Write down your goals and quantify them both in terms of dollars and time horizon.

Be sure to also factor inflation into your goals. For example, you may think you will need to have $500,000 (in today’s dollars) saved up in twenty years for retirement. But if you expect inflation to average about 3% into the future, you must grow this figure by the expected inflation rate in order to maintain the same buying power in the future.

To maintain the same purchasing power in this example in twenty years, you would need just over $900,000 in twenty years in order to purchase the same goods and services that $500,000 would buy today. You can use the Future Value Calculator to perform calculations such as this.

Risk Objective

The risk objective will be determined by both your ability as well as your willingness to take risk.

For example, do you have an emergency fund? Do you have outstanding consumer debt? Have you secured proper insurance coverage? Do you earn enough income or do you need to at least partially live off of your savings? What is your time horizon? The answers to these questions may determine your ability to take risk.

The willingness to take risk is the other side of the coin. Can you stomach a specific amount of volatility in your portfolio? Alternatively, are you willing to take unnecessary risk in order to achieve a return which is more than what’s necessary to meet your goals?

How Is Risk Defined?

Risk can be defined in different ways. But the most common one is standard deviation (volatility). Standard deviation measures the extent to which your investment returns may vary based on historical data.

For example, let’s say that stocks are expected (based on historical data) to return an average of 10% per year over the long term. Also, let’s say that historical standard deviation is 20%. Under a normal distribution , that means that about 68% of the time, annual returns would fall within one standard deviation around the mean (the expected return). This would result in a return range of -10% (10 – 20) to 30% (10 + 20).

A normal distribution (see below) is when the graphing of data (in this case annual investment returns) creates a symmetrical bell shaped curve. The more frequent returns are near the mean or average, which is in the middle of the bell. And the more extreme and infrequent returns are on either end.

normal distribution

While one standard deviation on each side of the mean covers about 68% of historical returns, two standard deviations would cover about 95%. Further, three standard deviation on each side of the mean would cover about 99% of historical returns.

Stock returns approximate a normal distribution curve over the long term.

Diversification Reduces Risk

When you diversify by combining different assets and especially asset classes into your portfolio, you can reduce risk. The reason being that the prices of different investments do not move in perfect unison.

In other words, they are not perfectly correlated. So for example, when one falls in value, another may increase. The lower the correlation among asset classes, the lower the standard deviation will be for the overall portfolio.

The one year standard deviation of large U.S. stocks (i.e., S&P 500) has historically been about 20%, for 10 year treasury bonds about 8%, and for cash equivalents around 3%. When you combine different asset classes, the blended standard deviation falls.

Time Reduces Risk

You should also understand that risk measured as volatility (or standard deviation) of investment returns decreases for returns over longer time periods. As such, don’t focus too much on one year standard deviations when your time horizon is over 15 years, for example. If you do, you may end up investing too conservatively. This can result in a relatively lower return which may be insufficient in meeting your goals.

You can estimate the standard deviation for longer time periods by dividing the one year standard deviation by the square root of the time period. For example, let’s say the one year standard deviation for stocks is 20%. To estimate the standard deviation for a 15 year time horizon, divide 20% by 15^(.5). You can use a calculator, Excel, or Google Sheets to perform this calculation.

The answer in the above example is approximately 5%. So the standard deviation falls from 20% for a one year period, to approximately 5% for a 15 year period. The reason for this is that the longer you stay invested, the closer and closer the total returns (on average) move towards the historical average.

Note, however, that the actual multi-year standard deviation may differ from the estimate above. Nevertheless, the concept that volatility decreases with a longer term holding period is a key point to remember.

Return Objective

This is where you specify how much you need to earn in order to meet your investment goals. You can use the Annual Rate Tool to get an estimate of how much you may need to earn on your investments in order to accomplish your objectives.

It is critical to set realistic goals for your investment returns. The major publicly traded asset categories are stocks (aka equities), bonds (aka fixed income), and cash equivalents. The historical average annual returns for these (and any) asset classes depends on the data source or index and time period used. But consider the following returns of some major asset classes.

Set realistic return expectations

Since 1926, the S&P 500 (U.S. large cap stocks) has returned about 10% per year. Bonds (10 year treasury bill) about 5%, and cash (treasury bills) about 3%. Given these returns, if you expect to earn 25% annually on average, you are likely setting yourself up for disappointment with unrealistic expectations.

Other considerations when figuring the return required to meet your goals

Take investment fees into account when setting return objectives. For example, you may need an average return of 8% to meet your objectives. But if your average annual investment fees are about 1%, you may need a gross investment return of about 9% on average to meet your goals.

The actual calculation would be 1.08*1.01 = 1.0908 – 1 = .0908 or 9.1%. Similar calculations can be made to adjust pre to post inflation returns and vice versa.

Note, however, that as indicated earlier, you can just grow the dollar amount needed for inflation by the inflation rate over the applicable time horizon in order to determine the estimated return needed to meet your goal. In this case, the return does not have to be adjusted for inflation. This way you avoid double counting the projected inflation in your calculations.

Adjusting required return for investment fees and inflation

Note: In the calculations below, make sure to enter the return%, fees % and inflation % in decimal format. So 3% would be .03.

net of fees return = (1 + return%) / (1 + fee%) – 1

net of inflation return = (1 + return%) / (1 + inflation%) – 1

return net of fees and adjusted for inflation = (1 + return%) / (1 + fee% + inflation%) – 1

So to convert the required return to the gross required before fees and inflation, you must multiply as follows:

gross return before fees = (1 + net return%) * (1 + fee% ) – 1

gross return before inflation = (1 + net return%) * (1 + inflation%) – 1

return before fees and inflation = (1 + net return%) * (1 + fee% + inflation%) – 1

Risk and Return Are Interrelated

You should also understand that return and risk are related. The higher the return you expect (i.e., more stocks) the higher the risk (volatility) will be, and vice versa. So you have to find a combination of investments which will meet the return and risk objectives for your personal situation and goals.

A 10% or so required rate of return may be inappropriate if you won’t or are unable to tolerate the risk or volatility that would accompany such a stock heavy asset allocation. You don’t want too much volatility in the short term to cause stress you cannot handle, or to compel you to sell out and abandon your investment plan.

Alternatively, for a longer term time horizon (see below), you may not want an overly conservative portfolio to potentially cause a negative return and thereby sabotage your goals.

You May Need to Save More and/or Adjust Your Goals

If the maximum rate of return is insufficient and/or the required risk is too high, you must either save and invest more, increase your time horizon, or otherwise prioritize and cut back or modify your goals. On the other hand, if you are already close to your goal, you may not need to take unnecessary risk to achieve a return much higher than what you need.

Pick a risk level that you are comfortable will be acceptable to you within two or three standard deviations from the mean (95% or 99% of the time, respectively).

Frequency and Amount of Contributions

How much will you contribute each month, quarter, or year towards your investment goals? The amount you contribute to your investment accounts, along with your rate of return, will determine if and when you will be able to reach your stated goals. Putting the contribution commitment on paper will help you to follow through and stick with your plan.

The more you are able to save and transfer into your investment accounts, the lower the return (and risk) needed to meet your investment objectives. And the opposite also holds true. The less you put into your investment accounts (all else equal), the higher the return (and risk) you will need to reach your investment objectives.

A personal budget can go a long way in helping you to set aside money for your investment goals.

Time Horizon

Your ability to accept risk is largely dependent on your time horizon. In other words, the length of time until you will need all or part of the investment funds for a specific purpose.

The shorter your time horizon for a specific goal, the lower your ability to accept risk. This is because higher volatility can result in a relatively large negative return, from which you may not have time to recover with a short time horizon. The opposite holds true for longer time horizons.

The strictness of your time horizon will also determine the risk you are willing to take. For example, let’s say you want to save money to travel the world five years from now. Are you flexible in this time horizon? Would you be willing to put off the travel a few years if your investments underperformed?

See our article on Target Date Funds for an example of how the asset allocation changes and becomes less risky (volatile) as the target date approaches.

You can sell risky investments and those without maturity dates such as stocks and stock and bond funds gradually as the target date that you will  need the money approaches. This may be referred to as “reverse dollar cost averaging.”

Also keep in mind that too little risk can be detrimental as inflation and relatively lower returns can result in shortfalls with regard to meeting investment goals.

Active or Passive Investment Philosophy

You can also indicate in your investment policy statement if you will be following an active, a passive, or a hybrid investment strategy. Active funds (i.e., mutual funds) or portfolios choose investments with the purpose of beating a particular benchmark or index.

Passive funds or portfolios aim to match the return of the index or benchmark, with fees and tracking error representing the difference in returns.

You can also choose a hybrid strategy where you invest in some index funds (passive), while also investing in specific stocks and actively managed mutual funds (active).

Asset Classes and Appropriate Benchmarks

You must identify the specific asset classes you will use to achieve your investment objectives. Then you must decide how you will weight each asset class in your portfolio to achieve your goals.

The investment firm BlackRock has a useful asset class returns PDF online. This can give you an example of the different ways into which investments may be categorized. It also provides historical 20 year returns for each category. This PDF also displays the volatility you should expect, as well as the benefits of diversification.

Appropriate benchmarks must also be selected for each asset class. For example, the S&P 500 Index is typically used as the benchmark for large capitalization U.S. equities. Benchmarks are useful in tracking how your portfolio investments are performing against the chosen benchmark for a particular category.

This is more of an issue with active portfolio strategies, where the goal is to surpass the appropriate benchmark. Passive strategies on the other hand, typically try to mimic the index. Nonetheless, as mentioned above, fees and/or tracking error typically cause differences.

Finally, you must decide what investments within each asset class you will use to fulfill your objectives. For example, you can use individual stocks and bonds, mutual funds, ETFs, etc.

See our article on diversification for more detail on different asset classes in which you may invest.

How Much Do I Allocate To Each Asset Class?

You must select a mix that will meet your risk and return objectives, and that is also appropriate for your time horizon. There are several ways to select a mix of asset classes for an individual portfolio.

For retirement goals, many individuals use a rule of thumb such as 110 minus your current age to determine the stock allocation. However, such shortcuts may result in inappropriate allocations for some as they only consider time horizon. Personal preferences, current resources and proximity to your goal may call for a different allocation.

Through the use of software, you and/or your advisor can use a portfolio optimizer to determine an appropriate asset class allocation. This type of software application utilizes the historical returns of different asset classes to construct a portfolio with the least risk (standard deviation) given a specific required rate of return. Or conversely, the highest rate of return for a given level of acceptable risk.

Portfolio Visualizer provides a free optimizer online. There may be other such free tools online as well. You can also purchase your own, or use one via your brokerage account. Financial advisors often use them in constructing individual portfolios.

Caveats of Using Statistics and Optimized Portfolios

It’s critical to understand, however, that average rates of return and standard deviations used commonly in constructing portfolios are based on historical returns. As such, there is no guarantee that the future will be the same.

In all likelihood, it will probably be at least somewhat different. Nonetheless, it can be useful to use history as a guide.

Garbage in, garbage out is a key concept to understand when using portfolio optimizers and other statistical models.

Rebalancing

You should review your investment portfolio once per year around year end. If the portfolio allocation percentages have moved more than 5% percent or so from their target levels, you should rebalance. This is done by selling and purchasing investments in the various asset classes to reestablish the target asset allocation levels.

Rebalancing is a form of contrarian investing, and allows you to implement the sell high, buy low concept of investing to a certain extent. For example, if your equity investments have outperformed your fixed income (bond) investments, you will sell some equities and purchase some fixed income investments.

Also understand that rebalancing can result in taxable events to the extent securities are sold at a gain and within taxable accounts (as opposed to tax deferred accounts such as IRAs or 401ks).

In addition to potential taxes, rebalancing also results in transaction fees. So this is another reason not to overdo it.

Other Investment Policy Statement Considerations

Here you can list other preferences with regard to your investment strategy. For example, you can indicate whether or not you will allow the risky practice of investing with the use of margin or leverage. Borrowing money to invest in publicly traded securities is generally not a good idea.

You can also indicate whether or not you will allow the use of derivatives such as options or futures, or other risky investments as part of your investment strategy.

See Investment Mistakes Can Cost You Dearly for more information on how to minimize setbacks in your investment portfolio.

Finally, you can specify some basic tax tenets to follow. For example, you can maximize contributions to tax deferred accounts such as IRAs, a 401k, and college savings plans before putting more money into taxable investment accounts.

You should also indicate the frequency with which you will review your investment policy statement. This should be at least annually and possibly whenever a major life event occurs.

Major live events can include death, a birth, an illness or accident, a marriage or divorce, change in employment, inheritance, the purchase or sale of a home, retirement, etc.

Conclusion

Clarifying how you plan on reaching your goals by specifying risk and return objectives, time horizon, and other preferences and strategies is very useful. It can help you to remain focused and stay the course in difficult times.

Of course future investment returns will be different from past performance. And your personal circumstances will change as you get older. But it helps to have an initial plan to follow. You can review your plan periodically and modify it when necessary as your personal circumstances change.

It’s also important to be aware of behavioral biases which can cause you to set inappropriate risk and return objectives.

Morningstar provides sample investment policy worksheet and investment policy statement templates online. You can use these or other templates along with the information in this article and elsewhere to help guide you in writing your own.

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