Investment policy statement

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Consider the use of a simple investing plan (see below):

  • For investors challenged by the complexity of an Investment Policy Statement
  • When the investment objectives don't justify the effort needed to create an Investment Policy Statement

An Investment policy statement (IPS) [1] is a statement that defines general investment goals and objectives. It describes the strategies that will be used to meet these objectives and contains specific information on subjects such as asset allocation, risk tolerance, and liquidity requirements.

Benefits of using an IPS

Every investor could potentially benefit from having an investment policy statement. It provides the foundation for all future investment decisions to be made by an investor. It serves as a guidepost, identifies goals and creates a systematic review process. The IPS is intended to keep investors focused on their objectives during short-term swings in the market and provides a baseline from which to monitor investment performance of the overall portfolio, as well as the performance of individual fund managers. If you are using some sort of financial advisor, an IPS outlines the ground rules of the relationship between you and that advisor. And you can use the IPS as a reference to see whether or not your portfolio is achieving your stated goals and objectives. Any proposed changes to your investments can also be evaluated and reviewed against your overall objectives using your IPS.

A properly constructed Investment Policy Statement provides support for following a well-conceived, long-term investment discipline, rather than one that is based on false overconfidence or panic in reaction to short-term market fluctuations.

Drawbacks of not using an IPS

Someone who doesn't have a written policy often bases decisions on day-to-day events, which often leads to chasing short-term performance that may hinder them in reaching long-term goals. Having a policy encourages maintaining focus on the long-term nature of the investment process, especially during turbulent or exuberant times.

Basic sections of an IPS

Financial account information

  • Where are your financial assets located?
  • How much is in tax-advantaged accounts (IRA, Roth IRA, 401(k), etc) versus taxable accounts?
  • How much will you be contributing to these accounts?

Investment objectives, time horizon, risk tolerance

  • Short-term financial goals and liquidity needs
  • Long-term financial goals and retirement
Time-frame for funding these goals
Length of time assets will be needed
Amount of assets to be needed

Asset classes to be used and those to be avoided

  • Asset classes I must include in my overall investment portfolio
U.S. Stocks
International Stocks
U.S. Bonds
  • Asset classes I would rather avoid due to excessive risk, high expenses, or large tax liabilities, etc.
Hedge funds
Actively-managed funds with high taxable turnover or distributions
Consider under-weighting tech sector due to my employment there

Asset allocation targets and rebalancing ranges

  • Target allocation between stocks and bonds
  • Target allocation for international investments
  • Time-frame for altering these allocations
  • Minimum and maximum deviations from these targets that will trigger portfolio rebalancing

Monitoring and control procedures

  • Frequency of monitoring
  • Benchmark for comparison of portfolio returns
  • Acceptable deviation from benchmark (amount and time)
  • Concrete procedures for future changes to IPS
Financial reasons for changing IPS
Lifestyle reasons for changing IPS
Reasons not to change IPS (e.g. short-term market performance)

Example IPS

Example IPS
Investment Objectives: These are my main objectives for my investment program. I have developed them after a review of my financial resources, financial goals, asset allocation, risk tolerance and time horizon.
  • Objective 1: To retire at the age of 57
  • Objective 2: To have an annual income from my investments of at least $45,000 after taxes and in today’s dollars (inflation assumed to be 3.0 percent yearly)
  • Objective 3: To leave a meaningful inheritance for my children
  • Objective 4: To minimize potential tax liabilities
  • Objective 5: To monitor portfolio allocation against holding limits, to benchmark returns against expectations, and to consider revisions to portfolio as personal situation may dictate
Risk Tolerance: My ability to tolerate the uncertainties, complexities and volatility inherent in the investment markets has been considered in the development of this investment program. The main factors that have influenced my risk tolerance and asset allocation are: age, present financial condition, specific financial goals, discretionary income and its variability, past investment experience.
Holding Limits: My portfolio was developed subject to certain holding limitations. These are limitations on the minimum and maximum percentage investment in each asset class:
  • Large Cap U.S. Equities (15-30 percent)
  • Mid Cap U.S. Equities (10-25 percent)
  • Small Cap U.S. Equities (5-15 percent)
  • Foreign Equities (5-15 percent)
  • REITs (0-15 percent)
  • Inter-Term Govt Bonds (10-25 percent)
  • Corporate Bonds (0-10 percent)
  • Cash and Cash Equivalents (5-20 percent)
Target Allocation: Based on my financial resources, financial goals, time horizon, tax status, holding limitations, risk tolerance and expected investment performance a recommended portfolio was determined. The portfolio balances risk and reward and attempts to achieve the stated objectives of the investment program. The initial asset allocation is:
  • Large Cap U.S. Equities (25 percent)
  • Mid Cap U.S. Equities (10 percent)
  • Small Cap U.S. Equities (5 percent)
  • Foreign Equities (15 percent)
  • REITs (10 percent)
  • Inter-Term Govt Bonds (25 percent)
  • Corporate Bonds (5 percent)
  • Cash Equivalents (5 percent)
Selection Criteria: Investment portfolios used to implement the investment program shall be subject to specified selection criteria and shall be monitored for adherence to my investment policy guidelines, major changes in the portfolios and comparative performance with similar investments. The expense ratio and overall cost of funds shall be a major point in the selection criteria. To minimize style drift, index funds are preferred, if available, for all asset class.
Review Process: My investment performance will be monitored and reported on a quarterly basis and will be compared against the appropriate benchmarks. The investment program will be reviewed at least annually to make sure that it continues to achieve his stated objectives. Since this investment program is long-term in nature, the periodic adjustments made to his investment program should be small.
Rebalancing: The percentage weighting to each asset class within the investment portfolio will vary. The percentage weighting within each asset class will be allowed to vary within a reasonable range of plus or minus an absolute 5 percent or 25 percent of the original allocation amount; whichever is triggered first. To minimize taxable events when rebalancing is required, dividends and net cash inflows will be used to meet the strategic asset allocation targets. If cash flow is not sufficient to meet the target allocation for an asset class, I will decide whether to effect transactions in order to rebalance the asset allocation.

Real-World IPS

Fellow Boglehead Sunny was one of the first to post a popular IPS. It may not cover all of the topics necessary for someone with a complicated financial situation, but his IPS is brilliant in its elegance and compactness. [2]

Sunny's IPS
Investment Philosophy: "Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth" - John C. Bogle
Asset Allocation: Maintain overall 60% stock + 40% fixed-income allocation until home purchase to accommodate both short-term and long-term requirements. Assets should be diversified across major asset classes including domestic equity, international equity (20-25% of equities), conventional bonds of short to intermediate term, and TIPS (50% of fixed).
Funds & Accounts: Use low cost mutual funds - index funds preferably - which do not overlap and provide maximum diversification across asset classes. Try to assume only market risk as far as possible. Try to shelter tax-inefficient funds in tax-advantaged accounts to reduce tax drag.
Target Allocation:
  • VTSMX - Total Stock Market Fund 45% - Taxable account
  • VGTSX - Total Int'l Market Fund 15% - Roth IRA
  • VIPSX - TIPS Fund 20% - Traditional IRA
  • IIBAX - Intermediate Bond Fund 20% - 401k
  • VMMXX - Money Market fund (6 months' expenses) - Taxable account
Other considerations: Automate future contributions wherever possible. Rebalance yearly. No market timing. Exact sub-allocations are not as important as maintaining the overall 60/40 stock/fixed allocation - no need to make things complex in order to meet sub-allocation targets.

Other real-world examples

Investing plan

In some cases, a formal investing policy statement may seem too complicated or inconvenient for some investors. In-lieu of a formal policy, an informal investing plan (also referred to as an investment plan) can be developed. Whether it's called a policy or a plan, the idea is that the investor has a clear understanding of managing their investment goals and objectives.[3]

The Bogleheads forum often gets questions such as “I have $50K saved up and I need to know which funds to put it in!”. Setting up an investing plan will help answer these questions.

An investing plan can be as easy as following these simple steps:

  • Step 1 - Formulate your goals. Be as specific as possible, realizing that you’ll make changes as the years go by.
  • Step 2 - Set up a plan for each goal. The plan consists of identifying what type of account you will use to save the money, choosing the amount you will put toward the goal each year, working out an asset allocation likely to reach the goal with the minimum risk necessary, and identifying a plan B for the goal in case the returns you’re planning on don’t materialize.
  • Step 3 - Select the best (usually lowest cost) investments to fulfill your desired asset allocation. Using all or mostly index funds further simplifies the process.

Some typical goals that can benefit from an investing plan:

  • I want $40,000 for home downpayment by June 30, 2013
  • I want to have enough money to pay the tuition at my alma mater in 13 years when my 5 year old turns 18
  • I want to have $2 Million saved for retirement by Jan 1 2030

For a detailed discussion on how to achieve those goals, see EmergDoc's Investing Plan Thread.

References

  1. Creating Your Investment Policy Statement at Morningstar's Investing Classroom
  2. Diehard Sunny Sarkar's beautiful IPS -
  3. EmergDoc's Investing Plan Thread

External links

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