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Why you need an investment policy statement

(MoneyWatch) There's an old and wise saying that those who fail to plan, plan to fail. Yet, despite the wisdom of this statement, the majority of investors never develop an investment policy statement (IPS). Having a plan is important because it's impossible to make rational decisions about investments without one. Properly evaluating investments means considering how their addition impacts the risk and return of your overall portfolio, and thus the odds of achieving the plan's objectives.

Just as a business plan must be reviewed regularly to adapt to changing market conditions, an IPS must be a living document. Unfortunately, it's my experience that even investors who develop plans often make the mistake of setting theirs and then failing to adjust them whenever major changes occur.

If any of a plan's underlying assumptions change, the IPS should be altered to adapt to the change. Life-altering events (such as a birth or death in the family, a marriage or divorce, a large inheritance or a promotion or job loss) can affect the plan in dramatic ways. The impact can be seen in one's ability, willingness or need to take risk. Thus, the IPS should be reviewed whenever a major life event occurs.

And it's not just life events that can impact a plan's assumptions. Even major market movements can lead to changes. For example, bull markets that produce greater-than-expected returns could put you ahead of where you need to be to reach your goals, allowing you to take less risk. However, bull markets also lower expected future returns, meaning that those still far from their goals may have to take more risk. (This doesn't mean you should take more risk. Alternatives might be to lower your goal, save more and/or plan on working longer.) The reverse is true of bear markets. A good policy is to review the IPS and its assumptions on an annual basis.

Before writing an IPS, you should thoroughly review your financial and personal status. You should consider not only your personal financial situation, but also such factors as:

  • The stability of your job
  • The correlation of your job and your stock holdings
  • Your investment horizon
  • Your tolerance for risk
  • The need for emergency reserves

Keep in mind that your investment horizon extends well beyond your planned retirement date. And it may even extend beyond your death if you're investing on behalf of your heirs.

You should also consider your need to take risk. Have you already saved enough? If so, why continue taking risk? Far too many investors fail to understand that the strategy to get rich (which is to take risks) is entirely different from the strategy to stay rich (which is to minimize and diversify risks).

It's also important to understand that it's not enough to just have a well-developed investment plan. It needs to be incorporated into an overall financial plan that also addresses estate and tax planning issues, as well as risk management issues such as any needs for life, health, disability, long-term-care, personal liability and longevity insurance. It should address when to begin taking Social Security. And your charitable intentions should also be addressed.

If you want to leave assets to family members, your plan should address how to transfer not only financial wealth to family members, but also your values. These objectives can be incorporated into what is called a family wealth mission statement. You should consider having your children involved in your estate plan, which includes reading your will and understanding your intentions with respect to your property upon your death. They should also know the family's net worth, and they should get to know your advisers (such as your attorney, accountant and financial adviser).

Another frequent mistake is to fail to develop a contingency plan -- the actions you'll take if your portfolio fails to deliver the returns that your plan anticipated. You should put in writing what specific actions you will take if a bear market leads to there being an unacceptable chance of your plan failing. You don't want to find yourself in a situation where your portfolio is likely to run out of assets or jeopardize an important goal. These actions might include:

  • Delaying retirement
  • Returning to the workforce
  • Reducing current spending
  • Reducing the financial goal
  • Selling a home
  • Moving to a location with a lower cost of living

The written IPS should be combined with a financial plan, which lists your specific goals, such as:

  • The amount you plan to add to your portfolio each year
  • The amount of assets you are trying to accumulate by a certain date
  • When you plan to begin withdrawals from the portfolio
  • The dollar amount you plan on withdrawing each year

This will allow you to track progress toward the goal, making appropriate adjustments along the way and staying disciplined no matter what the markets tempt you to do.

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