Last Thursday I challenged you to create an investment policy statement.
Today I’m going to help you.
Investment policy statements used to be only for big institutional investors managing pension funds. Maybe even a financial advisor with a multi-million dollar client would use one. However, I had a lot of success creating investment policy statements for clients late in my career.
They accomplished two things:
1) We had, in writing, exactly how we were going to manage the portfolio. That has more upside than you’d think. First, when bad stuff happened, we didn’t panic. Instead, we worked the system that’d we’d created while cooler heads were thinking about the issue. Second, when good things happened in the portfolio, we didn’t just lump everything over into that portion of the portfolio. People have a tendency to do dumb things with money, especially when you’re either making it hand-over-fist or you’re losing it like a virgin in a whore house. Yeah, that quick. Instead, you’re thinking through what you’re going to do and working the system. Don’t like the system? No problem. Rather than making moves on the fly, you change the system.
2) We knew what to expect from the portfolio ahead of time. Because an investment policy statement is created AFTER you know what benchmarks you’re shooting to achieve, it’s much easier to hone into the right portfolio than if you just pick asset classes you like and throw them together.
In short, I love investment policy statements because they save us time and money.
So, how do we do it? Easy.
1) We begin with the end in mind. Sounds like Steven Covey, doesn’t it? Well, every good plan begins with a goal, and once we know what it’ll take to reach that goal (see this post I wrote about goal setting and planning), then we know what return we’re after.
2) We find out what mix of assets historically would have given us that return. There is a lowest-risk investment strategy (historically) for each return we need. It’s called “the efficient frontier,” and using this will help us to create our dream mix of investments.
While I prefer to get more technical, simple asset allocation tools can be found all over the internet, like this one from CNNMoney.
3) We take a look at which of these investments I actually can invest in. If there are asset classes I can’t invest in, I make changes to the portfolio.
By “changes” I don’t mean doing whatever you think is best. What I mean is that you swap in similar assets into your asset allocation. Often I’d meet people who were using asset classes nowhere near their necessary goal.
I’d say something like, “Did you think that was going to reach the goal?”
They’d say, “Well, it was what I was comfortable doing.”
Does it matter if you’re comfortable? To some degree, sure. However, if you don’t realize that your comfort today is going to create a hell of a lot of discomfort down the road, I don’t think you’d make that tradeoff.
Now you’re ready to create your investment policy statement. Here’s what it looks like:
Your portfolio will be made up of: (fill in your asset classes)
Inside of each of these asset classes, I’ll use: (individual securities, mutual funds, ETFs, annuities….whatever. List the percentages you’ll use of each. Which types are prohibited?)
I will readjust my portfolio to make sure I have the right percentages in each asset class THIS often: (fill in how often you’ll make changes)
If the market falls X% (fill in for X), I’ll then begin to move assets out of (what area of your portfolio). I’ll move (fill in percentage) once a (week/month….how often) until (set condition).
I’ll re-add this money from cash back to the portfolio when (fill in the condition). I’ll put in (percentage of money in cash) back into the market over (time frame), once per (month, week….whatever).
There you have your investment policy statement. Fun? Absolutely. Better yet, it’s profitable……
More on that Thursday.
Frankly speaking the last part looked just like a flowchart.
As I’m a techie first and financial consultant second, this surely seems
interesting to me. Can’t agree more with your idea of financial statement
creation. This gives a clear visibility of financial investment plan along with
the probable contingencies. The clients remain more satisfied and informed
where and how their hard earned saving are getting investment. In fact, it also
helps the planners to give a probable projection on the amount of income that
they will be doing.
Though I agree with almost all the points, I have one
question where it seems I agree only partially and that is regarding the procedure
followed in choosing the asset. In the article you have written that assets
should be chosen on the basis of their historical performance. Yes, I agree
completely. But is this the only factor that should be kept in mind while
choosing an asset? I think the current fundamentals of a stock or asset class
should also be analyzed before choosing. This is because it has been found out
many a times that a historically good performing stock has deteriorated
fundamentals. Though the fundamentals have deteriorated, the company may be
posting good profit records by simply selling its own assets. So, from a long
run perspective this is not a good product to be put in your portfolio.
However, if you want short term gains then this stock may be out in the basket.
By making this point what I’m hankering on is that historically
good performing asset may have poor fundamentals. Therefore, it is always
prudent to cross check the fundamental factors of a stock or company before
choosing a stock on the basis of historical data.
Please correct me if I’m wrong.
You’re right. It IS a flow chart. One step flows to the next, and you don’t want to miss one.
As for historical returns, you’re also correct. My goal was to ensure that the vast majority of people reading this blog, who pick from thousands of investments, can instead stop wasting so much time with irrelevant investments and focus on the ones that have a chance of hitting their return.
If you follow the flow chart you’ll figure out your return needs and then you’ll know which investment types to begin with.
BUT you already know this….that now we’ve reached the beginning, right? That’s true. the sad thing is that CNBC talks over so many people’s heads that they don’t know that’s the beginning. My average question isn’t “what’s the standard deviation I should be looking for from my portfolio?”
The average question is, “Why do you hate BitCoin so much?”
See the difference? Start with the goal, find the efficient frontier, and THEN you’re at the starting line.
Thanks for the great comment!
Thanks and Welcome 🙂