How to Write an Investment Policy Statement?


Happy New Year! Many have new year resolutions from losing weight to learning a new language to making lifestyle changes. How about a resolution for your financial success by writing an investment policy statement (IPS)? 

Do you have an investment policy statement? If not, you should consider writing one. Because it will lay the groundwork for your financial success. In fact, think of your Investment Policy Statement as your “long term view” of your financial success. Mostly, your investment policy statement should consist of your ideas and decision making process that helps you reach your financial goals. 

Investment Policy Statement

Investment Policy Statement generally comprises three broader areas: investment goals, investment strategy and investment monitoring.

1. Investment Goal

The first step in writing an investment policy statement is to set your financial goal. One of the most common long-term goals is to accumulate enough to retire comfortably. If you google “how much retirement income do I need?”, the most common answer would be 75% to 80% of your yearly pre-retirement income.

However, the answer certainly depends on what kind of lifestyle do you want now or 10, 20, 30 years from now? Do you want to splurge now while you are young and not wait until your retirement? Do you want to sustain your current lifestyle and carry it through your retirement? Do you want to spend more than your current lifestyle in retirement? Answers to these questions will determine how much wealth you need to build. There are quite a few online tools that can help you with this such as this Retirement Income Calculator from Vanguard. 

2. Investment Strategy

The second step in writing an investment policy statement is to define your investment strategy to support your investment goals. In nutshell, this section answers questions like: how much to invest, where to allocate your investment, how much risk are you willing to take with your investment?

While the savings rate varies with your income level and your lifestyle, it is a good idea to invest 15% to 20% of your gross income if you can. It may not look like much in the beginning, but with consistent investing and compounding interest, your investment account could potentially grow into multi-million dollars over a few decades.

Where to allocate your savings depends on your age, your income level and most importantly your risk tolerance. Are you risk averse? What have you done with your investment in past bear markets? How did you handle paper loss of 30%? If you are not sure, review Vanagurd’s Portfolio Allocation Models to get started. 

Besides investment another important question to ask is: Do you need an emergency fund to cover unpredictable expenses? This is particularly important during the early accumulation phase. Because if you had unexpected expenses, the emergency fund will prevent you from derailing your financial stability.

How much in an emergency fund is enough? While it depends on your lifestyle, current savings, and job stability, the general rule of thumb is to allocate at least three to six months of expenses. Ensure that the emergency fund is liquid and is easily accessible. The best place for an emergency fund would be an interest-bearing checking or savings account. However, you should not invest in an emergency fund in a mutual fund or bond fund.

3. Investment Monitoring

The third step in writing an investment policy statement is to define how you are going to monitor your investment portfolio. 

  • How often will you review your portfolio?
    • Would you review it quarterly, twice a year or every year? 
  • What will you do with dividends and interest income?
    • Do you reinvest dividends and interest income or let it accumulate or use the income to cover expenses.  
  • How will you rebalance your portfolio?
    • Would you rebalance on frequency or when your target allocation is off? 

There are various rebalancing “rules”. One of the common rules is the “5/25” rule. According to this rule, you rebalance your investment if it deviates either 25% or an absolute 5 percent from its target allocation, whichever is less. For example, let’s say that your allocation is 60% Stock Fund / 40% Bond Fund. Due to the bear market, your allocation is now 55% Stock Fund / 45% Bond Fund. So you will “rebalance” your portfolio by selling 5% of the bond fund and buying the stock fund.

I know it is a lot to think about; however, this will be one of the most critical document for your financial success.

Investment Policy Statement Triggers

An Investment Policy Statement may need to be updated time-to-time. Here are some of the items that would trigger a change to Investment Policy Statement.

  • Change in target allocation
  • Introduction of a new asset class
  • Significant withdrawal from investment portfolio
  • Changes to savings rate
  • Changes to risk tolerance

Summary

After you create an investment policy statement, I suggest reviewing it once a year to make any necessary adjustment. In fact, you may not have to make any adjustments to your investment policy for several years. 

There you have it. If you have not created an investment policy statement, consider writing one today! 

Here is an example to get you started!

Investment Policy Statement: An Example

Investment goal:

Accumulate at least XX times our pre-retirement living expenses by the time we retire at age 65.

Or 

Replace 100% of current living expenses through savings and investment by XX age. 

Investment Strategy:

  • Invest at least 25% of our gross income.

Target Allocation

  • Equity Investment 70%
    • US Market: 50%
    • International Market: 20%
  • Fixed Income Investment: 20% 
  • Alternate Investment: 10%

Other Considerations

  • Invest in broadly diversified index funds
  • No more than 10% of the US equity market portfolio to a small cap index fund 
  • No more than 10% of the total portfolio in alternative investments such as real estate, private equity, and any other type of illiquid investments.
  • The majority of the bond allocation to US Treasury Bond funds
  • No more than 10% of the total bond portfolio in a Municipal Bond Fund (in a taxable account)

Investment Monitoring:

  • We will review our investment portfolio on a yearly basis.  
  • Rebalance: Once a year on my birthday. We will rebalance equity investment or bond investment if it deviates either 25% or an absolute 5 percent from its target allocation, whichever is less.





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