****The Investment Policy Statement

The purpose of the IPS is to put in writing exactly what you're trying to accomplish with your portfolio, how you plan to get the job done, and how you'll measure your progress along the way.  It should serve as the anchor that keeps you from drifting away from your plan to chase the latest hot tip or investment fad.  By helping you to stay focused on your long-term goals, it can also keep you from becoming so discouraged by the inevitable setbacks that you give up on investing altogether.  An IPS doesn't have to be a complex document, but it should include the following: 

• Your risk tolerance
• Your time horizon
• Your need for current income
• Your need for long-term growth
• Your plan of action
• Your schedule for measuring your progress

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Your risk tolerance

A great way to measure your risk tolerance is to decide what percentage you're prepared to lose in any given year without abandoning your strategy.  Be honest with yourself.

Translate the percentage numbers into real dollar amounts.  It's one thing to tell yourself you can sit calmly through a 20 percent decline, and another to open an account statement that shows one out of every five dollars of your hard earned money seems to have disappeared.  Since the markets tend to spend about a quarter of the time falling, sometime during your lifetime as an investor it's virtually certain that you'll be facing losses in your account.

Big return targets, whether for growth or current income, tend to increase the likelihood of big dips in portfolio value.  Investors are infamous for selling at market lows in a panic, usually just before the market recovers.  The more harrowing the ride, the more likely you are to want to get off.  Be sure you don't put yourself on the path to surrender by choosing too dangerous a route.  If you're not prepared to accept any declines along the way, then you're not entitled to the superior gains that stocks have traditionally provided.  That's fine; just scale back your plans to match the steady but lower long-term returns you'll probably be able to get from fixed investments.

Your time horizon

Your time horizon is simply how long you plan to maintain your current investment strategy.  It's usually tied to some major expense or event, such as the arrival of college years for the kids or a planned retirement date.  For investors already in retirement, the time horizon for an income portfolio may be their life expectancy.  The shorter your time horizon, the more conservative your plan should be.  As we have just witnessed, markets can go down for several years in a row.  While they have always eventually recovered in the past, the markets may not follow your timetable, leaving you short of the necessary funds when it's time to write the check.  In general, money you absolutely need to spend within four or five years should not be a part of your investment portfolio.

Your need for current income

Your need for long-term growth


The total return your portfolio provides is made up of two parts:

• income and
• growth. 

If your portfolio is providing you with the cash you currently need to support your lifestyle, you need income.  We believe there are potential pitfalls in relying on the systematic liquidation of portfolio growth ("dollar lost averaging") to fund your current income needs and that these pitfalls are serious enough to offer a strong argument for basing your withdrawals on the cash income your investments can generate instead.

 

How much money do you need to take from your portfolio today?  How much will you need in the years ahead as the cost of living rises?  Is your portfolio big enough to produce that much cash?  An investor with an $800,000 portfolio can get $1,000 per month by taking cash at just a 1.5% annual rate, while someone with $150,000 invested needs to draw cash at an 8% rate to pocket $1,000 per month.  If prevailing rates are around 4% and you need to take 12% to make ends meet, you've got trouble.  Your choices are to cut your expenses or shop at the high yield end of the investment market where risks are greater.  As the spread between what's reasonable and what's necessary grows, so does the likelihood of depleting a portfolio.

Those investors who don't need to take current income from their investments, or who have more than enough invested to meet their needs, can focus on growing their portfolios.  You'll still need to know your required rate of return - the total return you'll need to achieve, on average, to take you from where you are right now to where you want to be.  Answering the following questions will help you to find your required rate of return. 

• How much will your future goals cost once inflation is taken into account?
• How much have you accumulated so far?
• Where is the rest going to come from in the time you have remaining?
• Is there a rate of return you can reasonably expect that will help you get the job done, and can you actually achieve that return while staying within your comfort level?

Without the pressure of monthly withdrawals, investment income can be reinvested to provide for future income goals, inflation protection, or generational wealth creation.  As part of your total return equation, the level of income you should be looking for can be matched to the distance in dollars you have to go to reach your goals, and risk you're prepared to assume to get there.

Your plan of action

The description of your plan of action can be as simple as "Invest primarily in dividend-paying stocks," or as comprehensive as a complete summary of the details of your investment process.  The key is to create a benchmark against which you can measure every investment decision you make to help you keep your plan on track. 

Your schedule for measuring your progress

Plan on reviewing your progress at predetermined intervals spaced at least one year apart.  This is not the same as the process of regularly monitoring your securities.  It's a chance to take a fresh look at your circumstances to see if there have been any material changes in your income needs, time horizon, or risk tolerance.  The purpose of this review is to make sure your plan of action still makes sense given any changes in your situation, and to help you keep your overall investment experience tied to the long-term context of what you hope to achieve.  This review is about you, not about the markets.  The investment environment is always changing, and your plan of action already takes that kind of change into account.  Be careful not to let what's going on right now in the investment markets alter your strategy.

Keep a historical perspective in mind.  Big bull market advances don't last forever, and neither do major bear market declines.  So long as your process is performing as you would expect under the circumstances and still meets your needs, your Investment Policy Statement should not require a major revision.