How to Write an Investment Policy Statement

Make the Big Portfolio Decisions Before Emotions Can Influence You

Writing Your Investment Policy Statement
If you don't already have one, you should make a point to sit down and write an investment policy statement, or IPS, starting today. It will take awhile to put together fully, but once it is, it can serve as your guiding light through good times and bad, helping you keep perspective when it comes to managing your money. Yuri Arcurs / Getty Images

I've written in the past about developing your own investment policy manual but it's been a while since I've addressed the topic. I'd like to talk, specifically, about how you can draft an investment policy statement for your own family. Penning this document 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. One of the first things you will do is sit down with a representative of the firm overseeing your assets and talk to him or her as you fill out, together, the investment policy statement they use to internally guide their decision-making process as they buy or sell investments for you.

Take out a piece of paper, grab a pen, and get ready to jot down a few notes.  Think about these things over the coming days and week, then put aside time to actually complete the final investment policy statement, which you review 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.

Step 1: Define Your Objectives

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. For example, you 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 my piece on two of the time value of money formulas, you've already done at least a couple of these calculations without realizing it.

Step 2: Set the 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:

  • 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.  (To learn more, read "How Much Cash Should I Keep In My Portfolio?")
  • 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.
  • 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.

Step 3: 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" and pass several other tests a la old-school Benjamin Graham fundamental investing).
  • How regularly you will rebalance your holdings, or whether you will rebalance at all.
  • The measurement period you will use to determine if your strategy is on track. (Note: ​Anything less than 5 years is, if you'll forgive me, completely idiotic. 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 dumb.)

Final Thoughts on Writing Your IPS

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 like 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.