Financial advisors often prepare complicated investment policy statements (IPS) for their clients, complete with appendixes, footnotes, and legal disclaimers. But yours need not be a complicated one – rather, at its most basic and useful form, your statement would document the parameters of your investment plan – the asset allocation framework, criteria for selecting securities, and the system to maintain those investments on an ongoing basis.
Step 1: Document your goals.
Documenting your goals might seem straightforward, but there's more to it. Your goals needs to be described as must-have and good-to-have. For a middle class working couple – child’s education, buying a house and planning for retirements are long terms goals that the portfolio is expected to cover. On the other hand some of the good-to-have desires could be – a lavish farm house, leaving a bequest for the grandchildren and the likes.
Quantifying how much you will need for retirement is particularly complex, requiring you to forecast not just unknowables such as your life expectancy and rate of investment return, but also to factor in your own variables, such as how your spending might change in retirement and whether you have non-portfolio sources of income such as a pension. Multiple online tools or an exercise on Microsoft excel sheet can be used to document retirement needs.
Step 2: Outline your investment strategy.
This section specifically calls out your overall investment strategy to meet your goals. Your investment strategy must be based on your current situation. An investment strategy for retirees might be – to invest in dividend-paying equities and bond mutual funds to deliver periodic baseline of income; regularly rebalance to provide additional living expenses; target a 50:50 stock and bond mix.
While investment strategy for accumulators, for example, might be – to invest primarily in low-cost index funds, increasing contributions along with salary increases, begin with an 80:20 equity and bond mix and transitioning to 60:40 equity and bond by retirement.
Step 3: Document current investments.
Here you are documenting all of your scattered investments, as well as their most recent values. Be mindful to include all your investments – including retirement funds and insurances.
Step 4: Document target asset allocation.
Asset allocation play a vital role in the overall portfolio performance. It is said that around 80% of the overall portfolio performance is the result of selection of the asset classes and only 20% is reflective of individual assets within each class. While the asset allocation structure will depend upon individuals, a thumb rule for a young professional is to start with an overall 80:20 equity and bond mix and moving to 50:50 equity and bond mix upon retirement.
Because your portfolio's actual asset allocation is going to bump around a bit based on market performance, it is sensible to express your target allocations to each asset class as a range rather than a specific target. If your range for equities is 65 – 75 percent, for example, that means you will rebalance when your equities weighting goes below 65% or above 75%. For the major asset classes, a range of 5-10 percentage is sensible.
Step 5: Outline investment selection criteria.
Use this area to specify the characteristics that you will look for, in each investment type (and that you will hold them to, on an ongoing basis). For example, you might specify that each of your equity holdings must be large caps, or that your mutual funds must all be rated 4 or above. It is critical to follow the criteria that you have set for the portfolio and not get moved by short-term market swings.
Step 6: Specify monitoring parameters.
Implicit in outlining all of the above policies – from asset allocation to investment-holding specifics – is that you will periodically check-in on your portfolio to ensure that it meets your goals.
In this section, specify how often you will check up on your portfolio. A good start would be monthly monitoring and periodic rebalancing. Rather than rebalancing at specific time periods, rebalancing only when exposure to the major asset classes is 5 or 10 percentage points from the targets. (If you've set target ranges for your asset allocation in the section above.)
And because the best portfolio checkups are focused, it is best to specify what you will look for as you review your portfolio. Focus on the most important variables, like whether the portfolio is on track to meet its goals and whether its asset allocation is in line with the target range. Then, if time permits, you can focus on smaller-bore issues, such as your portfolio's performance relative to a benchmark with like-minded asset allocations.
The bottom line
Used in conjunction with a master directory, your investment policy statement (IPS) can be an invaluable tool for keeping tabs on your investments. An IPS helps you transition your investment collection to an investment plan. It will also aid your loved ones if, for whatever reason, they need to be able to obtain a quick and thorough overview of your investment plan.