How to Write an Investment Policy Statement

Investor Writing an Investment Policy Statement

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Penning an investment policy statement is, perhaps, one of the most important things you will do as you start your journey to financial independence because it can help you think long-term in the midst of even the most catastrophic economic maelstrom.

Truly, it might sound trite but the investment policy statement is not some creative writing exercise which you can shrug off -- it's serious business. Case in point: If you ever amass serious wealth, the odds are good you'll establish an individually managed account rather than invest through mutual funds or index funds.

Talk to Your Financial Advisor or Banker

One of the first things you will do is sit down with a representative of the firm overseeing your assets and talk to them. Learn if they have any internal guides to their suggested investment decision-making process. In some cases, this representative may make transactions on your account for you and in other cases, they may act as a custodian of your account.

Take out a piece of paper, grab a pen, and get ready to jot down a few notes as they walk you through their process. Be sure to ask questions on any terms or concepts you may not understand.

Think about these things over the coming days and week, then put aside time to actually complete the final investment policy statement. Revisit your investment policy quarterly, semi-annually, annually, or bi-annually to ensure you are still on track.

By making decisions when you are calm and the world is in order, you won't be as tempted to stray when there is blood running in the streets and television reporters are breathlessly screaming about the Dow Jones Industrial Average and S&P 500 collapsing.

Define Your Objectives and Risk Levels

What, precisely, do you want your money to do for you? Why are investing in the first place? You need to assign your wealth a job. Begin by sitting down and being honest with yourself about your objectives. Think about how much risk you want to take on in your investment. Remember that speculative investments have higher returns but you are at risk of losing your invested funds. For example, your plan might say:

  • I want a portfolio that generates dividends, interest, and rents of $5,000 pre-tax per month by the time I am 62 years old so I can combine it with my Social Security income and live a comfortable life.
  • I want to leave at least $100,000 as an inheritance to each of my children and grandchildren, possibly in a trust fund that distributes it to them as a group in equal installments over three years so they don't spend it all in one place or at one time.
  • I want to sleep well at night even if it means growing my money a little slower than I probably should. The emotional trade-off is worth it.

For the first two items, you can use a financial calculator to determine the amount of money you'll need to set aside, as well as the compounding rate you'll need to earn on your existing assets, to hit your targets. Don't worry, it's not as hard as it sounds. In fact, if you read about the time value of money formulas, you've already done at least a couple of these calculations without realizing it.

Set Your Asset Allocation Limits

Next, after considering what a good rate of return is for each of the different asset classes, you need to set up your asset allocation in a way that allows you to meet your objectives over your specified time frame. For example, you might say:

Maintaining Cash and Cash Equivalents

I will always, without exception, maintain at least 10% of my personal net worth in cash and cash equivalents so if the world falls apart, I don't have to worry about buying groceries, gas, or medicine. This money does not have to earn a return. Sure, keeping pace with inflation is ideal but it is not the primary concern. It is a reserve; my anchor to windward. 

Maintain High-Quality Dividend Holdings

I will always, without exception, keep at least 20% to 40% of the portfolio in high-quality, blue-chip stocks that pay dividends, even when the stock market collapses by 50% or more. These are the giants of domestic and international commerce that make up the backbone of the global economy. They might seem boring, and they might not appear to grow as quickly as some next-big-thing stock, but they can get the job done while giving me peace of mind because they should always be worth more ten or twenty years from now regardless of the interim volatility.

Maintain Real Estate or Cash Generation

I will keep at least 20% of my portfolio in directly-owned, cash-generating real estate in my hometown. It will be a backup residence if I need to move out of my home and downscale, offering an added dimension of utility. The rental income will help me fund my other investments and its low correlation with the stock market returns gives me a degree of safety that I otherwise wouldn't have enjoyed.

You'll have to work out the details but arriving at the right mix for your lifestyle can help you avoid finding yourself in a poor situation.

Establish the Mechanics of Running the Portfolio

You need to decide how often you will evaluate your portfolio to make sure you are within your predetermined limits and hitting your compounding fence posts.

The investment philosophy you will use to add new securities or funds to your portfolio (e.g., when we talked about the conservative buy-and-hold blue chips earlier, you might say, "I will only consider stocks that have increased their dividends for at least 15 years in a row.

Determine how regularly you will rebalance your holdings, or whether you will rebalance at all.

Set the measurement period you will use to determine if your strategy is on track and working. Anything less than 5 years isn't smart. The academic evidence on this is clear. If you're going to compare your portfolio to a benchmark monthly, or even yearly, prior to 60-month rolling increments, you're probably going to do something wrong by selling or buying at the wrong time.

Final Thoughts on Writing Your Plan

Make sure you write out, sign, and date your investment policy statement to keep yourself accountable. If you say you aren't going to allow a single stock or bond to exceed 5% of your portfolio, stick by your guidelines.

If you are going to keep a certain amount in tax-free municipal bonds as an emergency fund, do it. Think of it as the portfolio equivalent of a prenuptial agreement, only it's between you and your money. It's a lot easier to make decisions calmly beforehand when it's all wine and roses.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.