We make many agreements with ourselves, several of which are based on the values we received growing up from our parents and family. Or we emulated our friends' values based on those that resonated with us. Sometimes, it could even be a character we saw in a movie, read in a book, or some character we imagined in our dreams and cannot explain where it comes from. There are a host of agreements we make with ourselves most commonly: personal, professional, emotional support, and spiritual practices. Here is one that is less commonly known for individuals to have but one that could have a considerable impact: An Investment Policy Statement.
What is an investment policy statement (IPS)?
It is a document that outlines an individual's or entity's investment goals, strategies, and decisions. It serves as a roadmap for managing a portfolio and making investment choices. Various types of investors and organizations typically have an IPS, including Individual Investors (hey that is you!), Family Offices, Investment Companies, Fund Managers, Institutional Investors, Non-Profit Organizations, Retirement Plans, and Trustees of a Trust Fund.
An IPS is a fundamental tool for any investor seeking to manage investments in a systematic and rational way. Part of that rationality emerges when friends, families, or strangers approach you, seeking your financial support for an investment. It can be your invisible bodyguard when saying no to an investment that does not work with your long-term policy and strategy. An IPS can help when evaluating investment decisions, and it could also provide a structure to evaluate investment performance, set expectations, and ensure alignment with your assumptions and goals. It can also be you tough friend that reminds you what your parameters are/were when you are considering a investment that materially deviates from your stated plans.
The Value of an IPS
Similar to values, having a policy statement helps to provide a buffer when making decisions. I remember being pitched, completely off guard, for an exotic animal farm in South Texas. It was pitched by a financial professional as a great tax strategy. Whether it was or wasn’t, I will not know as the investment option did not meet many of my investment policy statement criteria. And hey, to cold switch and pitch an investment when a call is for a different purpose is a surefire way to get a warm, no thank you. Some language I have used in the past and certainly supplied as my response: “Thank you for sharing this opportunity. I will pass. This does not fit with my investment policy statement.”
The IPS Framework:
If you have not had a policy statement previously, here is a framework to help you as you create your own:
Investment Philosophy: Here you will define your overall investment approach. Below is a quote I have incorporated into my philosophy statement:
"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
Your philosophy should be simple and straightforward. Investing is not complicated, it is just not easy to stay consistent when emotions want to start driving decisions.
Asset Allocation: Here, you can go into details of the different investment asset classes you would consider. Here is a slide from one of my programs that walked folks through different asset and investment classes.
You are probably wondering why I have “Yourself” as the first asset class. Well, I believe that investing in your professional development, taking on new experiences, projects, etc., helps you to continue to grow your income. We are all looking for investments that grow cash flow. You can be a never ending investment if you so choose. If that is not enough, consider the current financial system we operate in. Having a strong w-2 is a good thing if you are looking to buy real estate or a business with leverage from certain big-named financial institutions. In my opinion, they care about if you are cash flowing. They are underwriting you not the investment. Now certainly other less known financial institutions will underwrite the investment to see if it is cash flowing, etc. however expect the terms to be less favorable than the routes frequently traveled with too big to fail institutions.
Other Thoughts on Asset Allocation
Based on your style, operating mode, etc., some of these asset classes may be ones choose to ignore. For example, for me, I don’t see this asset as a cash flowing asset. I’m looking at assets that can be held and ultimately create cash flow. This is just my approach. If your approach is different, then great. You do you, as they say. No need to try to convince and save me. Having a difference of opinion is what makes a market.
Funds and Companies: Here is where you would talk about the use of mutual funds vs. ETFs as structures if you are interested in index investing. Also, here is where you would talk about the kinds of companies you would invest in and which ones you would stay away from.
As an example, I’m not a fan of companies that carry a lot of debt. While we cannot quantify all risk factors, I can say companies that are heavily-leveraged to debt don’t have a lot of flexibility and freedom to embrace any future that will come their way. To stack up dollars to pay down debt keeps companies focused on past decisions. Consequently, there is less money to focus on future profitable growth investments and other capital allocations strategies. Such other strategies include: bolt-on acquisitions, dividends, and stock repurchase that are purchased at below fair value prices and reduce the float count.
Asset Location: It's not just what you own but which investment account you own it in that can impact your financial results. This is a topic more frequently talked about if you have a financial advisor (and a good one at that). It is also a topic talked about in your IPS.
Theoretically, investment returns seem easy to measure, yet when you dig, you will see it's actually harder to quantify. Take into account the tax implications of where your assets are held (Taxable Brokerage Account, a Tax-Deferred Account, or a Tax-Free Account). Ideally, let’s pay the lowest taxes we can, place assets in a tax-free account like a Roth IRA, Roth 401K, or HSA (where the withdrawals are for approved medical expenditures).
For those who are efficient, this is considered “tax alpha”, which could help up to 1%. Take a look at JP Morgan’s article on the subject.
Also, here is Fidelity's article on investment types to consider per account location:
Other Thoughts on Asset Location:
As account contributions and asset selections are made, monitor account balances to ensure you have a good balance between the three account location types. Having a high tax deferred account balance (Rollover IRA/401K) could have long term tax and Medicare IRMAA implications thus reducing the after-tax returns.
Understand the tax implications for Index Mutual Funds vs Index ETF’s. ETFs are more tax efficient. Take a look at this Fidelity Article that explains this in greater detail. This is an area I’m personally focused on.
Keep in mind if you have built up large gains in your mutual index fund and you would like to switch over to an ETF index fund, it might not be as easy to maneuver given the tax consequences of selling one fund for another (even if they are quite similar).
Consider the estate tax consequences for those who may inherit your accounts. Depending on your total net worth value at the time of death, there may be a tax consequence. So be intentional about which funds you have in which account location.
Individual stocks in different accounts matter. If you have individual stocks in your taxable account, then these are ones you want to love for many many years as the tax bill associated with built in capital gains will be a hard pill to swallow at the time you no longer want to be with the company.
Target Allocation: Here is where your level of investment involvement will help define your allocation. And keep in mind, unless it is a money market account, there is really no such thing as passive income.
Certainly, you can hire an advisor to help you with this, however, know before you go the asset allocations you would be interested in. Otherwise you truly give your sovereignty way. Also, keep in mind your advisor fees can be steep over a long time horizon. For example, 2% or 1% of assets under management can be worth millions of dollars by the end of the financial plan. The actual fees may not sound high or actually be millions of dollars but rather the lost compounding associated with those fees is what will stunt your net worth. Want to learn a little more on this subject? Catch up on this article for a primer.
All this to say, figure out what exactly you would like for a financial advisor to do for you. Define the scope of the work and then negotiate a price that is commensurate.
Investment Returns History:
Time managing your investments will matter, so will the average returns associated with each investment. See the data from NYU Stern. You may be surprised by the rates of return by asset class. For example, Real Estate is not as high a return as some would imagine. When you add in the time involved to manage the investment, you can decide what options are right for you.
Fund Strategies:
Here are slow and steady compounding paths to wealth. This is based on taking a long-term and consistent approach. It assumes a long time horizon, low investment fees, investing in highly liquid public markets, and staying invested.
***I am no a financial advisor, and this is not financial advice.***
This is just educational material for you to start studying a few allocation methods as you get started on your own research. Find and create a strategy that works for you.
Age-Based Approach – this is a single fund strategy that adjusts over time as you age. The fees on the fund can be high, but that is due to the work involved in creating and managing this fund.
Two Fund Strategy: age-based funds that include some growth aspects. This scenario includes fixed-income aspects, cash, and equities. Here is a video if you wish to dive deeper. Paul Merriman makes the argument for a two fund approach.
Side note: I’m not a big fan of small-cap companies for a host of reasons I won’t get into here. However, I do think there is something to learn here about risk management and balancing it with building wealth.
Three Fund Strategy: This approach uses the basic asset classes typically associated with a broad-based allocation of stocks and bonds. Here is an article from the Bogleheads wiki site.
Buffett Trustee Advise: In Berkshire Hathaway’s 2013 annual letter Warren talked about his allocation strategy advice for his wife’s trust account that would be bequeathed at the time of his death.
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors.”
There is a good rebuttal to this allocation strategy. Consider reading this article to make sure you are looking at views for and against a strategy before you make a decision. In short, Buffett’s time horizon, need for funds, risk tolerance are probably different than ours. However, Buffett’s overall point that investment allocations can get complicated and with high fees —these are pretty good ways to not grow wealth.
To help you think through your investment strategy and how others operate successfully and not so successfully in the market, consider reading "The Psychology of Money" by Morgan Housel. It is a good book on the wonders and follies of humans and money.
Timing: Here, you will talk about your frequency of contributions (automatic vs. manual), whether it will auto-purchase, etc. Again, not advice, but my experience has been, if things are not auto scheduled, things just do not happen. We all get busy.
For me, I have things set up on a schedule to be auto processed. My only manual effort is setting up that first meeting with myself to think through things and then get them scheduled.
In addition to getting contributions and/or purchases scheduled, this section will also include the frequency of auto rebalancing. You will also include what you will do when markets get exciting or troubling. Will you be someone who tries to time the market, etc. As for me, I’m completely not a fan of timing the market. There is a great deal of evidence that demonstrates it works most times against the retail investor.
An item to include for personal investors, includes the timing of Roth Conversions. This is the conversion from Pre-Tax Accounts to Roth Accounts.
A strategy among many to consider: converting when good quality companies or funds are experience a market correction. If you plan to hold an investment and they experience a discount, then it might be a good time to do a conversion vs tax loss harvesting.
Risk: Here is my newest area I'm spending more time exploring to deepen my understanding. At a high level, go beyond the general risk assessment that then equates to aggressive growth, growth, conservative, etc. Ugh...these do not tell you very much IMHO. Here are some things to consider when managing risk: understand the probabilities of an outcome; unpredictability is inherent in investing; and the whole saying "the greater the risk, the greater the reward" is all wrong. The goal is to be invested for decades in the proverbial market. If an investment is do or die, then it makes it much harder to be one of the last players standing.
When considering risks for yourself, keep in mind, risk can include falling short of return goals, credit risks, illiquidity risk, concentration risks, leverage risk, and a wider range of possible outcomes among some of the risks we need to consider in our policy statement.
Ways to help mitigate these risks include:
Falling Short of Return Goals: save more, live below your means to help build up more funds.
Interest Rate Risk: this was Silicon Valley Bank. Understand the impacts of interest rates on your investment plan.
Illiquidity Risk: if your home is your largest equity investment, start building up other investments that are more liquid. Consider if you plan to downsize your home when you retire to access more of your equity. Keep in mind, there has to be a buyer for what you are selling in order for you to access your home’s equity in a cost-efficient fashion.
Concentration Risk: if a company stock makes up a meaningful portion of your investments, start looking around: at the quality of the company, long-term growth prospects, debt levels of the company, whether you need the funds now or ever, etc. Unless the company is a true unicorn like Berkshire with a stock price of $19 in 1965 and today is valued at $611,070.19 (3/15/2024), most companies do not keep their values going up and to the right for this long a period.
Leverage Risks: debt is not a friend. Manage accordingly.
Range of Possible Outcomes: We tend to only think of investments going up; what if things swing and we experience a 30% drop in values (circa 2001, 2008, 2022)? What does that do to us personally, emotionally, and professionally? How can you embrace any future that comes our way?
Other: State what your accounts will be used for. What are the accounts’ purposes? What job will be done for each of your accounts? These are good questions to ask yourself especially if you discover you cannot quickly answer them. Just this past week, a loved one and I did this for some accounts. The question works if you are willing to be thoughtful, sit a moment, and ponder why the account was opened in the first place.
Other questions to ask yourself: Will the account be accessible to you immediately or only when you hit a certain age?
It’s a Wrap!
Happy exploring what your investment philosophy, style and policy statement will be. It will take time to set up and may end up being a two page document. An IPS will save you a great amount of time in the end and it will be a good and strong bodyguard for you in the future!
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Disclaimer: This newsletter and podcast are not financial advice. Rather this is educational information as you build your financials skills to be a better sovereign of your own finances.