Investors who are organized and have a clear understanding of what they’re trying to accomplish are far more likely to succeed than those who are casual about their money. One of the most effective ways to make investing easy and methodical is to develop a personal policy statement that answers basic questions and issues that come up repeatedly.

For example, consider this situation: “The stock funds in my portfolio have done so well for the past year that this does not seem the right time to rebalance. Shouldn’t I wait a few months and see what the market does?” If you don’t have a policy, you may have to wrestle with this question each time the situation arises. That can lead to bad decisions made in order to gain emotional relief. By developing a policy, you address the issue once and decide how to handle it in the future, adding a bit of discipline to your investments.

A good investment policy is a written document (it doesn’t have to be very formal) that guides you, your financial advisors and all other relevant parties in planning, managing, monitoring and evaluating your portfolio.

It’s never too late to develop a policy, and the benefits usually can be seen quickly.

A comprehensive investment policy has four parts: setting measurable goals, defining realistic risk-adjusted investment performance, maintaining a portfolio and determining communication procedures.

SETTING FINANCIAL GOALS

This is the heart of personal financial planning. Unless you know where you’re going and when you need to be there, you’re unable to tell whether you are on track. The objective of this step is to set specific goals that can be measured.

Vague goals such as being “comfortable” at retirement or sending your children to “good” schools aren’t helpful. Neither you nor anybody else can objectively measure whether or not you attain them.

It’s helpful to prioritize your goals so you can determine which ones will demand attention now and which ones can wait. One mistake many families make is postponing retirement savings while they save for children’s college expenses. Retirement savings should not be postponed or sacrificed. Ideally, these two major goals can be funded simultaneously.

Young people who reach college age without sufficient resources usually have many more options open to them than parents who reach retirement age with insufficient savings.

Each goal also can be linked to a source of funding it. For example, if you want to buy a sailboat, your written goal might specify that you’re willing to save 10 percent of your discretionary income for no more than five years.

That implies that at the end of that time, you’ll determine whether you have enough to get the boat of your dreams. If not, you’ll re-assess this goal and either drop it, modify it or find another source of funding it.

Here are some pointers for setting goals:

Divide your list of goals into two groups: high-priority items that must be met even if it requires a change in your lifestyle and negotiable goals that you’ll seek only to the extent that there’s room to fund them in your budget.

Put each goal in writing, along with a due date or some span of time in which you want to fulfill that goal.

Put a price, in today’s dollars, on each goal. If you will need to incur debt, as in a mortgage, specify how much you’ll need for a down payment, and be sure to take into account the monthly payments you’ll have to make.

Don’t forget that inflation will increase the cost of your goal. If you’re saving for college expenses, you should assume they’ll rise faster than the overall inflation rate.

For each goal, decide how much you’re willing to spend. Ask how much you are willing to save, and for how long. Ask what other goals, if any, you are willing to sacrifice for this one. Determine a plan for what you’ll do if you can’t meet the goal within your specified time frame.

Here’s an example of what a prioritized goal list might look like:

DEFINE REALISTIC, RISK-ADJUSTED INVESTMENT EXPECTATIONS

In this step, you start by determining how much return you will need from your investments. The more time until you need the money, the more important this step is. For goals due in six months, investment returns won’t be a significant factor. But long-term goals such as retirement may be heavily dependent on your rate of return. The first number you need is your projected annual living expenses in retirement. A conservative approach is to assume that you’ll need 100 percent of your pre-retirement income. If you like, you can subtract items that will disappear after you retire such as contributions to your 401k plan and IRAs. But don’t forget that your medical costs may rise as you get older.

Then add up the annual income you can count on such as pensions and Social Security. Most likely this “assured” income will be less than the amount you need. The difference or gap is the amount that you’ll need from your portfolio each year. At some point you will want to very carefully determine how much money you will need in order to retire and how much you will withdraw from your investments each year. These are extremely important issues, and the time to address them properly is before you take the leap into retirement, not afterwards.

I recommend that when you are a few years away from retirement you meet with a professional financial advisor to make sure you are taking into consideration all the things that you should. If you’re 10 or more years away from retirement, you can make a quick-and-dirty estimate of how big your portfolio should be when you retire. Just multiply the annual amount you’ll need from your portfolio by 20.

Do not take this formula as gospel. Instead use it to give you an idea of how big your portfolio must be – so you know whether or not you are saving enough. If you have a flexible lifestyle, you can plan on withdrawing a fixed percentage of your portfolio’s value in each year instead of a fixed dollar amount. If you do that, your withdrawals will vary depending on the performance of your portfolio.

Next, determine your risk tolerance, then choose the appropriate asset classes and the percentages they should make up of your total holdings. For each asset class, state a target percentage and an allowable range of percentages.

Your policy statement should also specify what kinds of investments you will use.

Here’s an example:

I will need $30,000 a year from my portfolio (before taxes) to supplement other retirement income from age 60 through 90. I can accomplish this with my current savings if I earn an average annual return of 9 percent. I can tolerate no more than a 30 percent drop in the market in any 12-month period. Based on historical returns, this means I can handle a portfolio, if it is well diversified, composed of 70 percent equities and 30 percent fixed-income funds. I believe the allocation I have outlined will accomplish my objective within my risk tolerance.

At least 90 percent of the investments I hold in each asset class will be in no-load mutual funds. If any individual investment I own drops in value to 65 percent or less of what I paid for it, I will review with my advisor whether I should sell it or buy more of it.

MONITOR YOUR PROGRESS

Once you invest, your portfolio will inevitably deviate from the theoretical steady annual returns in your projections. Your investment policy should establish how and when you will monitor your performance and rebalance your portfolio to restore your target allocations.

In choosing a benchmark, look for something that at least approximates your asset allocation and that is consistent with your risk tolerance and your target return.

Your rebalancing schedule should be determined after taking into account your cash flow needs, trading costs, the status of other asset classes and tax consequences.

Here’s an example:

My portfolio will be rebalanced once a year based on the asset allocation criteria above. I will have a formal meeting with my advisor annually to determine if this plan is still appropriate for my goals and my current financial situation.

The benchmark for this portfolio will be the following:

COMMUNICATION PROCEDURES

This part of the policy spells out the roles to be played by your advisors. It should specify how often you will routinely consult with your advisors and other details.

Here’s an example:

My financial advisor will conduct a formal review once a year and rebalance my portfolio twice a year. Beyond that, my advisor will make recommendations based on my overall goals, my tolerance for risk and my current financial position.

I will notify my financial advisor of any important changes in my financial or legal circumstances and will play an active role in making decisions concerning my investments.

At least once a year my advisor and I will review whether my investment returns are on track to achieve my goals on time. If they are not, we will identify and review possible steps I can take now to improve my position.

CONCLUSION

The preceding is an example and does not cover all the issues that should be addressed by a comprehensive investment policy. Your written policy can be more complex, taking into account the tax status of your accounts, periodic additions and/or withdrawals as well as any unique circumstances you may have.

As you can see, adopting an investment policy statement requires time, work and thought. But whether the end result is complex or simple, if it is done correctly, this process can make a huge contribution to your financial well-being.

Editor's note: This article was written by Rachele Cawaring, formerly managing advisor at Merriman. 

 

 

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