Writing an investment policy statement

Once we have a financial goal identified and a time frame for meeting that financial goal, then it is time to put down in plain English the specific plan we will undertake to go about meeting that goal.  This will involve writing an investment policy statement.  All big financial institutions, such as bank investment departments and mutual funds do this and their investment policy statements are usually several pages in length.  They use their investment policy statements to set down the "rules of engagement" whereby they will invest their customers' money. Of course, our investment policy statements will be much simpler because we are investing only for ourselves. We just want to get down in writing a plan that will guide our actions in meeting a financial goal.  This statement will also be a reminder to us as time goes by just how we should be investing so that we don't get off track.  In a word, it provides us with the discipline that we need so that we will not let our emotions dictate our actions when the going gets rough. 

And believe you me, the going can get very rough!  The market meltdown of 2008 is a very recent example of just how rough the going can get.  Losses in investment portfolios of 30% to 50% were not uncommon and a lot of the selling of stocks were by folks who were flat out scared to death that their investments would be worthless.  So a lot of people did just the opposite of what we know we should do.  They bought high and sold low, which is always a guaranteed loss.  Had those who panicked held on to their stocks they would have largely regained their losses the very next year as the stock market made a stunning comeback from the previous record lows.  Even today, some people are so fearful that they have permanently vowed never to invest in stocks again.  And that is o.k. if your aversion to risk is so great that you can't sleep at night worrying about your stock investments.  Just realize that if you are one of those who have given up on stocks, that your investment options to achieve your financial goals will be significantly reduced.  Stocks will continue to provide the best choice to keep pace with inflation and provide a sufficient return to help us achieve our financial goals, in my opinion.

Your odds of achieving your financials goals will be greatly enhanced if you have a well-thought out written plan to follow.  So with that in mind, let's look at how we can get our investment policy statement down on paper.  Let's use a fictitious married couple in our example of developing an investment policy statement.  Meet Joe and Liz Simpson (no kin to Homer and Marge).  Joe is 35, Liz is 33.  They want to begin an  investment program to provide funds sufficient for retirement income when Joe turns 65. They both work and have 401(k)s at their workplace, but they want to have a separate investment portfolio apart from work to supplement their 401(k)s. 

• Step 1-  State your financial goal.  In the case of the Simpsons, this could be stated as:  Save to provide sufficient funds for retirement in 30 years.  So we have the goal and the time frame stated simply.  We have a long term time horizon in which to invest, so stocks could definitely be an option for investing.
• Step 2- The first step provides the "why" we are investing part, so the next steps will determine the "how" part of the equation.  In step two, we determine that since this is a long term retirement goal, we can take advantage of one to the tax advantaged retirement programs.  In the case of the Simpsons, they decide that they would like to contribute to a Roth IRA.  This would complement their participation in their 401(k)s at their workplaces.  The contributions to the 401(k)s provide them with tax deferral and they get a tax deduction right off the top because they don't pay taxes on the money that they contribute.  On the other hand, the Roth IRA doesn't provide the upfront tax deduction but the earnings in the account are not taxed as in the traditional IRA or a 401(k).  In addition, distributions from the Roth IRA are not taxed, whereas the distributions that are eventually taken from the 401(k) are taxed at the participant's income tax rate at the time of the distributions.  So, to get to the point, the Simpsons decide that each will contribute $5,000 to their respective Roth IRA accounts each year, which is the maximum for the year 2010.  So far, our investment statement reads:  We will undertake an investment program to supplement our 401(k) savings so that we will have sufficient funds to provide income in retirement starting in 30 years by each contributing $5,000 annually into a Roth IRA.  Please note that we haven't gone into specifics as to what dollar figure that we are talking about.  That is, just how much money are the Simpsons going to need at retirement.  For purposes of illustrating the concept of an investment policy statement, we are not going to get into specific figures.  For one thing, the computation of a specific figure requires us to make a lot of assumptions about such things as inflation rates and rates of returns on different asset classes.  It also requires a lot of number crunching that is best left to a trusted adviser to help you out with.  He or she will have the necessary knowledge and the necessary tools, such as sophisticated computer software programs, to help you arrive at a specific figure.  To keep our illustration simple, we will simply state that the Simpsons
• Step 3- Decide on which types of investments to have inside the Roth IRA.  Government regulations allow all sort of investments inside an IRA.  For our purposes, we are only going to consider the 3 most common types:  stocks, bonds, and cash.  This is to keep our example simple and also because stocks and bonds will most likely be the major part of any long term investment.  The Simpsons decide that they are going to invest their IRAs in mutual funds.  This is, in my opinion, a wise decision on their part because with mutual funds you can get instant diversification.  The proper mutual funds will provide you with diversification by allowing you to own the stocks and/or bonds of a hundred or more companies with your initial investment.  Buying individual stocks and bonds is out of the reach of most investors just starting out and it takes an awful lot of expertise not to mention time and energy to make the specific selections.  
• Step 4- Determine the percentages of  stocks and bonds inside the Roth IRA.  In general, the more stocks inside an investment, the riskier the investment is going to be.  But their is a trade off between risk and return, because if you invest too conservatively, that is stick mostly to bonds,  the rate of return we can expect will likely be reduced.  What we want is what is known in investment parlance as "the optimal portfolio", that is, one in which we can get sufficient return to meet our investment objectives but will still allow us to sleep at night.  This involves determining your "risk tolerance" which is just a fancy term for assessing your ability to cope with failing to achieve your target rate of return, and yes, most of all to tolerate losses in your portfolio.  There are currently a number of risk tolerance questionnaires to help you determine your risk tolerance and you can take them to see how you score, but the best advice I can give you here is to always take as little risk as you can to achieve your investment objectives.  In our example, the Simpsons have 30 years over which they can invest, but I would recommend to them to still have only about  60% to 70% allocated to stocks.  This percentage should decrease as time goes on and this points out the fact that any investment statement policy that you come up with should be reviewed at least annually to make needed adjustments in your portfolio.  So far, the Simpsons investment policy statement reads:  We will undertake an investment program to supplement our 401(k) savings so that we will have sufficient funds to provide income in retirement in 30 years by each contributing $5,000 annually into a Roth IRA.  Our IRA investments will be in diversified mutual funds with a 70% stock allocation and a 30% bond allocation. 
• Step 5- Select the specific mutual funds.  In the case of the Simpsons, since I am going to pretend to be their investment advisor, I am setting them up in two mutual funds.  The stock fund will be the Vanguard Total Stock Market Index Fund and the bond fund will be the Vanguard Total Bond Market Index.  These two funds will give them a broadly diversified portfolio across the two major asset classes and will keep their investment expenses very low.  They will not be trying to pick out a particular actively managed fund that may or may not outperform the index fund (most under perform).  At the same time each year, they will rebalance the percentages inside the IRAs so that they maintain their desired percentage.  For example, if stocks have a good year so that the money inside the IRA is now invested in 65% stocks and 35% bonds, then at rebalancing time, they would sell 5% of your stock mutual fund shares and buy shares of the bond mutual fund to bring the balance back to 60/40.  It's that simple.

We now have the Simpson's investment statement policy:  We will undertake an investment program to supplement our 401(k) savings so that we will have sufficient funds to provide income in retirement in 30 years by each contributing $5,000 annually to a Roth IRA.  The money contributed to our IRAs will be invested such that 60% will be invested  in the Vanguard Total Stock Market Index Fund and 40% will be invested in the Vanguard Total Bond Market Index Fund.  This stock/bond percentage will be maintained by rebalancing annually.  (Note: If the Simpsons decide to reduce their stock percentage as they get closer to retirement, then they can take the opportunity at rebalancing time to adjust this percentage. This stock allocation reduction could be done each year or every other year, every 5 years, and so on. If they decide to do this, then this should also be stated in the investment policy statement.)

Just for information purposes, if the Simpsons follow through with their investment plan of contributing $10,000 $5,000 each) annually to their Roth IRAs, and they can get an average annual return of 8%, after 30 years they will have accumulated $1,132,832.  And they will not have to pay any taxes on this money at any time.  What a sweet deal!  Having a written plan will increase the odds that you can do just as well.

Wishing you the best,
Randy
randy@mooreadivser.com