Creating Your Investment Policy Statement:
Big organizations create them for their company retirement plans. Financial advisors craft
them for their clients. They require some philosophizing and number crunching. And
when done thoughtfully and comprehensively, they can be 15 pages long.
What are "they"? Investment Policy Statements, or IPSs.
An IPS isn't only for the well-heeled who love paperwork. It's a must for all investors.
That's because creating an Investment Policy Statement forces you to put your investment
strategy in writing and commit to a disciplined investment plan. It's both a blueprint and a
report card. A typical IPS consists of six sections
1. Executive Summary;
The Executive Summary provides an overview of your current situation and what you
expect from your portfolio. It's a snapshot in time. Update your Executive Summary
whenever you rebalance your portfolio.
Here are the questions to answer:
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What are the current assets of my portfolio today?
How much do I plan to invest each month?
How many years will I be investing?
How much do I expect my portfolio to return each year over inflation?
How much of a loss can I accept over a three-month period, a one-year period,
and a five-year period?
What is my target asset allocation?
What are my benchmarks for my portfolio?
When it comes to answering the final question, choose your benchmarks wisely. Say you
have a portfolio that's 40% invested in U.S. large-company stocks, 10% in U.S. smallcompany stocks, 30% in bonds, and 10% in foreign stocks. Don't use the S&P 500 as
your portfolio's benchmark. It's inappropriate. After all, the S&P 500 is made up strictly
of U.S. large-company stocks. The S&P 500 may be a suitable benchmark for the 40% of
your portfolio that's comprised of U.S. large-company stocks, but not for your entire
portfolio.
In most cases, you'll need to use a combination of benchmarks to measure the success of
your portfolio as a whole and the success of your individual investments.
You'll also need to decide over what time periods you want to benchmark your portfolio
and your investments. Do you want to benchmark your portfolio's annual returns? Its
three- or five-year returns? Some combination thereof? It is recommended keeping
abreast of your returns yearly, but focusing mostly on longer-term results.
2. Investment Objectives:
The Investment Objectives portion of your Investment Policy Statement details what
you're trying to achieve with this portfolio and in what time frame.
Answer the following questions:
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What is my financial goal?
How long will I be funding this goal?
How much will this goal cost every year?
3. Investment Philosophy:
In the Investment Philosophy section of your Investment Policy Statement, you'll
articulate what's important to you as an investor. These are the theories you believe in
and plan to follow.
Here are just a few questions to consider:
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What's my philosophy about risk?
What's my philosophy about core versus noncore investments?
What's my philosophy about diversification?
What's my philosophy about trading?
What's my philosophy about costs?
What's my philosophy about taxes?
Before you buy or sell any securities, make sure that your actions reflect your philosophy.
If they don't, ask why. Maybe you shouldn't be buying or selling that security. Perhaps
your action is based on short-term performance, or a hunch about what the market is
going to do. But your actions should be based on your Investment Philosophy.
4. Investment Selection Criteria:
The Investment Selection Criteria section of your Investment Policy Statement includes
your rules for choosing investments. These rules will vary significantly from investor to
investor, based on each investor's Investment Philosophy. Think of these criteria as a
means of quantifying your philosophy.
To determine what qualities an investment must have before joining your portfolio, Some
criteria to consider for mutual funds:
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Minimum total return % category rank over various periods
Maximum percentage of assets in top-10 holdings
Maximum percentage of assets in any one sector
Maximum expense ratio
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Minimum or maximum asset size
Minimum manager tenure
Minimum tax-efficiency ratio
Some criteria to consider for stocks:
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Maximum price for each stock
Minimum return on equity
Minimum free cash flow
Minimum forecasted five-year earnings-growth rate
Maximum leverage
Minimum dividend yield
Minimum market capitalization
Maximum price/earnings ratio
Minimum revenue growth rate
Any new investment that you're considering for your portfolio should meet these criteria.
If it doesn't, why not? Do your criteria need to be altered? Or is this an investment that
you shouldn't make given your philosophy?
5. Monitoring Procedures:
The Monitoring Procedures portion of your Investment Policy Statement details your
plan for keeping tabs on your investments. It's your blueprint for rebalancing, and for
determining what investments, if any, you should sell.
Answer the following questions:
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How often will I monitor my portfolio?
How will I determine how well my individual investments are doing?
How will I determine how well my overall portfolio is doing?
How will I determine if my portfolio is meeting my expected return?
How will I determine whether losses fall within my accepted range?
To determine how well your individual investments and overall portfolio are doing, be
sure to use the benchmarks you chose in the Executive Summary section of the
Investment Policy Statement. If you find that your portfolio is not meeting your expected
return, or that losses are falling outside of an acceptable range, you may need to adjust
your investments.
When monitoring, don't focus only on performance, though. Make sure the reasons you
chose these investments in the first place still apply. To do that, check the status of each
investment against your Investment Selection Criteria. If a stock or fund no longer meets
your criteria, it may be a sell candidate.
6. Revisiting Your IPS:
Once you've created your IPS, sign it, date it, and come back to it in a year. The
Investment Policy Statement isn't only your investing blueprint. It's also your portfolio's
report card.