Do You Need an Investment Policy Statement?

Do You Need an Investment Policy Statement?

Yes, you do. How’s that for a succinct answer? But in case you don’t know what an Investment Policy Statement (IPS) is, or how it’s utilized, here’s a brief explanation.

An IPS is a written document that basically describes how an investor’s money is to be managed/invested. Every publicly-traded mutual fund and ETF is required to have an IPS, as is every ERISA-regulated retirement plan such as a 401(k). An IPS should also be created by an investment committee charged with making investment decisions for an endowment or pension plan, or by a professional investment advisor working with individual clients or families. You can even create your own IPS if you are a do-it-yourself investor.

The key benefit of an IPS is investment discipline. When markets become volatile, investors can become rattled. Unfortunately, we tend to do exactly the wrong thing when we react to market movements based on emotion. When markets start dropping, we tend to sell our investments in order to feel more secure. When markets are soaring, we tend to follow the herd and buy when prices are high.

An IPS provides guidance for how investment decisions should be made. It is a policy document rather than an implementation plan, and, as such, should help you avoid making emotional-driven decisions. Here are some of the key elements that an IPS should include:

  • Your future goals (expenditures) and savings expectations. This includes your investment time horizon, the timing of your anticipated withdrawals and deposits, and your need for reserves or liquidity.
  • Your investment objectives (i.e. your target return). Although no one can predict or control the returns you will actually get, you cannot plan for your future without having some expectation of investment returns.
  • Your attitude towards risk and volatility. Remember that your risk tolerance is different than the risk you have to take in order to try to achieve your target return.
  • Any constraints on your assets, such as liquidity and marketability requirements, diversification concentrations, and asset location for tax efficiency purposes. You might, for example, want to invest only in publicly-traded mutual funds and ETFs. In addition, you may want to avoid investing in companies that do not meet your standards for social responsibility. You may also choose to limit your investment in any individual asset to less than 10% of your total portfolio to keep diversification as broad as possible.
  • An asset allocation model and rebalancing frequency. This is fundamental to a sound investment strategy. The more asset classes included in the model, the better the diversification. The IPS will typically include a range for each asset class (e.g. between 20% and 40% international stocks) to allow for variability under different economic conditions. Having a stated rebalancing frequency helps to eliminate the inclination to time the market, which research has shown to be impossible to do consistently.

Interestingly, investment advisors are not required to create an IPS for each of their clients. Nonetheless, it’s a best practice that all advisors should follow. Successful investing requires a strategy, and an IPS is an excellent way to define it and communicate it.

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