- An Investment Policy Statement (IPS) allows you to make investment decisions before markets get volatile.
- Your IPS helps take the emotion out of investing by establishing clearly defined rules around your portfolio.
- Checking your IPS regularly and rebalancing back to your targets can help you take advantage of market movements.
If I gave you $10,000 to invest tomorrow, how would you decide how to invest it?
What if stocks were down 30% next month (like they were in March of 2020). How would you react?
Would emotion get ahold of your decision making, or would your investment policy statement guide the way?
Having a written investment policy is key to taking the emotion out of investment decision making. And emotional decision making is an investment return killer. Sometimes while markets are running up we get fear of missing out (FOMO) and buy in at higher and higher prices with no exit plan. This happened to many emotionally driven investors in the tech bubble of the early 2000’s. On the other hand, you probably know someone who sold all their investments in 2008, after the market had already dropped significantly, only to miss out on the eventual recovery of their investment. The same thing would have happened if you panic sold in March of 2020, and we will see these ups and downs countless times over the course of our investment lifetime. From 2000 – 2019 the stock market retreated at least 10% 11 out of 20 years.1 How do you keep a level head when your account balance is bouncing up and down?
Having a written Investment Policy Statement (IPS) is your guide to level-headed investment decision making.
The largest investors in the world (pension funds, university endowments, and the like) use investment policy statements, and individual investors can and should use them too. What makes them so valuable?
1. An Investment Policy Statements defines your investment strategy2
Having an IPS sets clear rules for your investing. Will you own stocks, bonds, or some combination of the two? In what amounts will you own each of them? Will you add international investments to your mix? And are there any investments that are off limits?
If you have a clear investment policy, when you receive that unexpected $10,000 to invest you already know exactly where to invest it based on your predefined plan.
2. An IPS helps you manage your investment risk
Your IPS helps you avoid becoming too overweight in any one investment, which helps to manage your overall risk. Your investment policy may say you want to have no more than 60% of your money invested in stocks. If we have a big year for US stocks like we did in 2020, that can start to shift your portfolio balance towards even more stock. String a couple years like that together and you can become more heavily invested in stocks, and therefore riskier, than you planned on being. Checking your portfolio vs. your investment policy regularly can help your risk level stay in line.
3. Your Investment Policy is (ideally) developed during calmer times
When you create your investment policy statement, ideally you are thinking about your ideal portfolio. You’re not thinking about how much the market was up or down this day, week, month, or year. Instead, you’re just thinking about how much risk you want to take, making sure your portfolio is diversified, and setting up rules around your investing.
By establishing your investment policy in calmer times, when things do get crazy (and I assure you they will) your calmer, collected self has already decided what the target for your portfolio is, and all you have to do is adjust as things become out of line. We call this rebalancing. Which leads me to #4…
4. Sticking to your investment policy can help you buy low and sell high
Buy low and sell high is the oldest rule in the book. When most people think about this, they are thinking about buying the next Amazon or the next Apple low, and selling it higher in the future. We know though that timing the market is very difficult. Not only do we have to predict the future to decide which low price stocks are the ones to buy now, making wrong moves can mean we wind up buying high and selling low instead.
This is where your investment policy statement helps. Let’s travel back in time to March 2020, and stocks have fallen substantially. If we compare the amount of stock actually in our account versus the targets in our investment policy statement there is a good chance we will see we are now under invested in stock as a result of the drop in value. Our investment policy tells us to buy additional stock to get our stock holdings back up to their predefined targets. The IPS creates a natural signal to buy low by simply observing changes in your portfolio, not by trying to time future movements and predict the market.
Having a well-defined investment policy statement helps to take the emotion out of your investment decisions. It allows you to think long-term and plan out your investment strategy ahead of time, and not rely on spontaneous decision making at times when all you see in you account are red arrows and negative numbers. If you are working with an investment advisor, ask about your investment policy statement, and if you don’t have one ask why. If you’d like help crafting yours, reach out to us for help putting a disciplined strategy in place before you need it.
All written content on this site is for information purposes only. Opinions expressed herein are solely those of CWFP, unless otherwise specifically cited. Jeff McDermott and CWFP are neither an attorney nor an accountant, and no portion of this website content should be interpreted as legal, accounting or tax advice. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. Investment involves risk and unless otherwise stated, are not guaranteed. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.