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.