Your Investment Policy Statement (IPS) serves as a guide for when you encounter inevitable market volatility or you think about changing your investments on a whim. It’s a clearly written policy that explains how your portfolio will be managed. It takes account of your goals, investing philosophy, risk tolerance, and other holdings. It is intended to keep you on track and keep you from making changes that could be detrimental, especially during market volatility. It provides the who, what, why, where, and how of managing your portfolio.
Who is the IPS serving?
The first section of your IPS will explain who you are and provide background information. This will likely include your family situation, risk tolerance, and timeframe. A clear understanding of who you are provides the direction for the remainder of the IPS.
What are you trying to accomplish?
This is the goal that you are investing to achieve. It may be retirement, college funding, a home, or anything else that is important to you. This can be a vague statement to provide flexibility, such as “long-term growth.” But it is better to be as specific as you can because it allows for a more tailored approach to managing the portfolio.
Why is this important to you?
It is important to keep in mind why you want to accomplish these goals. Research has shown that people are more likely to reach their goals if they focus on why they want to achieve a goal. Each time you review your IPS you will be reminded what you are working towards. If your priorities have changed, then it might be a good time to reassess your goals more generally and update the IPS.
Where are you investing?
This starts with the asset allocation–your mix of stocks and bonds. The asset allocation will be the biggest determinant of your portfolio’s returns and risk. It is based on your risk tolerance and the time frame you are investing.
Your risk tolerance is determined by 3 factors. First, your capacity to take risks with your investments is determined by your need for the funds and ability to make adjustments. Second is the desire to take risks. This is more subjective; it simply depends on what you are comfortable with. Third is the need to take risks. Based on your estimated rate of return, how much risk must you take to reach your goals?
The time frame will need to take account of the amount of time until distributions begin and the duration of those distributions. For example, one would invest a portfolio for retirement differently than a one-time purchase. This is because a retirement goal requires a series of distributions over many years, while a one-time purchase requires only one distribution.
After you decide on the asset allocation based on your time frame and risk tolerance, you will need to decide which securities to use. While every investor is unique, it generally makes sense to use a portfolio of low-cost, well-diversified index funds. These can be used to build a portfolio tailored to your needs without becoming too concentrated or losing too much of your returns to fees.
How are you investing?
Inevitably the market will fluctuate. This causes your asset allocation to drift from its target. The IPS should explain how you will react to these fluctuations. This will include rebalancing bands for asset classes. For example, the portfolio may require rebalancing if it drifts by 5 percentage points or more. This would mean a portfolio that is 60% stocks and 40% bonds would be rebalanced if the stock portion rose to 65% or dropped to 55%. Having a clear rebalancing plan in place helps keep investors on track to meet their goals and keeps the portfolio from becoming unnecessarily risky.
Stay on track
A clear plan helps keep you on track when the unexpected happens. If the market is down, you will have a clear course of action to address this with your portfolio. Are you worried about a specific area of the market? Your IPS will explain how to handle this.
These differences are not just theoretical. Research has shown that investors who have a clear plan earn better returns and are less likely to worry about their portfolio. This is not because the individual investments perform better; it’s because the investor has the confidence to stick with their plan and refrain from selling during market downturns.