Chapter 8 – Formalize Your Investment Plan

Chapter 8

Formalize Your Investment Plan with an Investment Policy Statement

You have already done most of the work in making a plan by developing your asset allocation and  asset class percentages. Now you have to formalize it by writing it down. If that seems a bit excessive, it isn’t. Writing down your objectives, goals, and strategies:
1. declares you are serious
2. Protects against behavioral mistakes
3. helps you remember the details
4. helps you stay focused
5. makes you aware of something you may have missed.

Preparing for the future—managing money, saving, and investing—is a serious responsibility. It is no different and no less important than earning a living, maintaining a house, or protecting the things you’ve worked hard to get. The formal plan follows the same logic you might use for your next vacation, remodeling your home, or planning for your children’s education. Not planning results in nothing being done or making mistakes that waste time and money. To put it in more graphic terms, not planning and not following the plan can have a serious negative effect on your retirement life. None of the other investment rules will work in the long term without a plan and the discipline to stay with it.

A plan doesn’t need to be complicated, but it is so important that the experts agree that an investment policy statement be written and signed. A vision without a plan is an illusion. Here is what Lewis Schiff, author of “The Armchair Millionaire” has to say: “Define your financial goals and time horizon. What goals do you need to achieve in order to be financially secure or independent? For most of us, these goals would include having a certain amount to secure retirement. Your plan might target long-term growth, current income, protection of your capital, or some combination of all three. Other major goals might include college education or purchase of a home. These goals, with different time frames and different priorities will require their own investment strategy.
Define your risk tolerance.
Define your target asset allocation.
Define your individual investments.

The bottom line: All of your investing decisions should be grounded in your own investment policy statement (IPS). By taking a ‘top-down’ look at your finances and writing out a road map, your policy will add an important element of discipline to your approach.”

Sticking to a plan can be difficult at times. Any investment plan will be occasionally challenged by the market and second-guessed by the investor. The market will challenge your asset allocation decision at times by making it look like you’re doing it all wrong. Various sectors and segments of the market can get hot and everyone around you is jumping in. Even your best friend is clobbering your returns. On the other hand, the whole market may take a nose-dive and all you hear is gloom and doom. Temptation to join the crowd or rein in stock allocations can be very strong. These pressures can lead to common behavioral mistakes, which can be the major cause of losses for individual investors. You must be efficient in capturing all of the potential returns you can.

Ninety percent of what you read and see is useless noise and must be ignored. That’s easy to say, but actually very tough to do. Listening to noise is one of the major mistakes investors make and why you absolutely need to commit to a strategy and put it in writing. I don’t mean to say you should not alter your asset allocation when life style or goals change, but don’t flinch for any other reason. Take into account what might make you flinch, then set your allocation accordingly from the start.

This is the sort of blitz you are up against as Paul Farrell notes in an April 2005 Marketwatch article: “Last year, I estimated that the average investor was being overwhelmed by 43,000 fund and stock recommendations, via newspapers, magazines, cable television, radio and the Internet. The intensity of this noise confuses and brainwashes investors, resulting in costly mistakes.”

Chandan Sengupta, in “The Only Proven Road to Investment Success,” also warns of the danger: Noise is a constant problem and you have to recognize it and then dismiss it as not only worthless, but harmful. If you are not going to stick to your chosen investment method through thick and thin, there is almost no chance of your succeeding as an investor.”

John Brennan, in “Straight Talk on Investing” sums up the planning process nicely: “Making a plan need not be complex. It is all about looking ahead and assessing where and when your needs for money will occur. Then you decide on how you’re going to meet those needs. It’s essentially a three-step process:
1. Determine how much money you’ll need to have.
2. Figure out which kinds of investments should provide you with the money.
3. Calculate how much you need to set aside in order to make those investments.”

Your plan needs to consider building assets and managing existing assets in all accounts, including tax-deferred accounts at work like a 401(k) or 403(b), IRA, Roth IRA, as well as taxable accounts and emergency funds. Once that is done, you can subdivide your plan into individual goals. Goals with different time horizons will require different allocations, but it is best to keep the overall top-down view for a full perspective. Generally, money allocated to goals within a five-year time period should not be in stocks. The one exception, of course, is retirement. You will need to keep some stock in retirement because you will still be investing throughout your retirement years.

You can come up with an investment policy statement yourself or get some assistance from a financial advisor. Just remember, you need to have some idea of where you’re going and how you want to get there. If you don’t, an advisor may not be able to provide effective help. Here is an example of how a long-term plan for retirement might look:

IPS (Investment Policy Statement)
1) Investment Horizon – 30 years
2) Risk Tolerance – High due to investment horizon and evaluation of both financial and emotional ability to handle dramatic losses.
3) Financial Objective—2 million dollars. This objective can be achieved by starting with a sum of $30,000 and adding $12,000 per year for 30 years while getting a return of 8.5%. This financial goal will allow me to withdraw $80,000 per year (4%) beginning at age 62 for at least 30 years with a high probability of preserving the principal.
4) Rebalancing: I will review my allocations once per year (Feb.) and I will make adjustments by adding new money to adjust percentages back to targets.
5) Primary Asset Allocation: 75% equities, 25% fixed income
Equities – 70% domestic, 30% international
Fixed income – 100% domestic
Equities: Domestic allocation – Total market 25%, Large Value 25%, Small Value 10%, REIT 10%, Total International 30%
Fixed income: Total 25% of Portfolio – 25% Treasury Inflation-Protected Securities, 65% total bond market, 10% hi-yield
6) The plan allows for reduction in equity allocation as retirement gets closer and risk tolerance decreases. Allocation changes may also be evaluated if life-style changes or significant new goals occur. I will not let investor sentiment and Wall Street noise influence my allocation.


When should you get serious about an investment plan? Right now!
Here is a link to additional Information on Investment Policy Statements. Note that the first part is a quite detailed overview of what you need to think about. The second part is a detailed example. The third part is a real-world example. Notice that it is not complicated or lengthy.

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