What is your personal investment policy?

What is your personal investment policy?

May 06, 2022

There is a lot of wisdom in simplicity, especially when it comes to investing. You do not need advanced degrees and genius-level intelligence to be a successful investor. Mostly it requires common sense and a lot of discipline. Warren Buffett spoke to this idea in a 2010 interview published in Forbes magazine. He said:

“You don’t need a lot of brains in this business. I’ve always said if you’ve got an IQ of 160, give away 30 points to somebody else, because you don’t need it in investments. What you need is emotional stability. You have to be able to think independently, and when you come to a conclusion, you have to really not care what other people say. Just follow the facts and your reasoning.”

Buffett’s statement may sound simple, but this kind of emotional stability is difficult to develop and maintain. This is why most institutions and many investment advisors use investment policy statements (“IPS”). An IPS communicates specific information about how a portfolio is to be managed. Investors armed with a clearly written IPS are less likely to let short-term emotional reactions undermine their long-term strategy.

A well-written IPS summarizes the portfolio’s objectives, including the amount and timing of expected withdrawals, acceptable asset classes, diversification requirements and risk tolerance. The IPS includes a description of the portfolio’s target asset allocation and how much the portfolio can deviate from the target before it is to be rebalanced. By following the instructions spelled out in the IPS, the investment manager is able to keep faith with the original intent of the portfolio.

The following questions can help you get started on developing your own IPS. If this seems daunting, you may find it worthwhile to work with an experienced advisor.

1. What is your investment horizon? Investment horizon refers to the length of time your portfolio will be active. For example, if you are developing the IPS for your retirement account, your investment horizon will be the number of years remaining in your life expectancy. If you are investing for a date-specific event, such as your child’s college education, your investment horizon will be the number of years until that date arrives. Some institutions, like endowment funds, may have horizons in perpetuity.

2. What is the appropriate asset allocation? This is driven by your investment horizon and the expected withdrawal requirements from your portfolio. Portfolios with long-term horizons (i.e., anything longer than 10 years) should be heavily weighted toward stocks. Those with horizons shorter than 12 months, should be invested in cash-like instruments (i.e., CDs, money market funds, etc.). Portfolios with horizons in between should be invested in a combination of bonds and stocks with shorter horizons tilted more toward bonds and longer horizons tilted more toward stocks.

3. Which risks worry you most – market volatility, bankruptcy, or inflation? Some risks are more relevant than others. For example, everybody faces bankruptcy risk in their portfolio which is why every IPS should emphasize portfolio diversification. A good rule of thumb is that no individual stock in your portfolio should account for more than 5 percent of your overall portfolio value. If you are investing in funds, your IPS should require that you to check the fund holdings to make sure they are compliant.

The relevance of some risks is driven in large measure by your investment horizon. Many people worry about market volatility. This risk is most relevant if your investment horizon is less than 5 years. However, if your investment horizon is 10 years or more, market volatility is less of a risk in practical terms. On the other hand, inflation is a subtle but relevant risk for long-term portfolios. Even very small amounts of inflation can have a dramatic effect on the real value of your portfolio over horizons of ten years or more. You can protect against inflation by investing in stocks.

After thinking through these questions, you are ready to draft your IPS. Keep it simple, clear, and concise. Start with a paragraph summarizing the goals of the portfolio, including its investment horizon. Follow with a paragraph outlining your target asset allocation and rebalancing guidelines. Finish with a short discussion of the key risks you are trying to mitigate. Nothing is written in stone, so go ahead and experiment. If your IPS doesn’t work for you, you can always change it later.

Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have about investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.