DON’T Invest a Single Dime Without this Crucial Document

Imagine hiring a builder to construct you a home. You tell the builder how you want the home to look and you tell them about all your desired features.

Instead of showing you a blueprint, the builder starts construction and a short-time later, your house is completed.  But there’s a very big problem: The home’s final design is nothing like what you imagined, beginning with the popcorn ceiling. What went wrong?

Because of a mutual failure by both the builder and the owner (you) to finalize the home’s design and agree upon these details in writing, the end product is a total disaster.

(Audio) Are You Overpaying for Financial Advice? + Be Ready for the Small-Cap Effect

Similarly, all investors should have a written investment plan. In the financial services industry this written document is commonly referred to as an “Investment Policy Statement” or “IPS.”

The purpose of an IPS is to define the investor’s goals, strategy, and final destination.

Some of the basic things an IPS will describe are the following:

  • The investment objectives of the investor(s) and the strategy to achieve the goal
  • The investment portfolio’s target asset allocation
  • The portfolio’s rebalancing frequency
  • The investor’s risk tolerance and investment time horizon

Of course, a well-written IPS will go beyond the typical and generic details listed above.

For example, in the IPS used at ETFguide, we deliberately segregate portfolio assets into three groupings: 1) core portfolio, 2) non-core portfolio, and 3) margin of safety. Aside from helping investors to be better organized with their money, this disciplined framework keeps people out of trouble because it controls risk.

Moreover, instead of merely limiting the IPS to describing how much money is supposed to be allocated toward stocks (NYSEARCA:DIA), bonds (Nasdaq:LSBRX), real estate (NYSEARCA:VNQ), commodities (NYSEARCA:DBC), and cash (Nasdaq:SPRXX), it should also tell the investor which types of accounts the assets should be held in to aggressively reduce the threat of taxes to the greatest degree possible.

Shockingly, most individual investors – even those who have hired a financial advisor – are investing their IRAs, Roth IRAs, 401(k) plans, and other life savings without a written IPS. Why? The viewpoint that an IPS is strictly reserved for large institutions with billions of dollars at stake is both antiquated and wrong. All individual investors – large and small – have skin in the game and should thus have a written outline of how to avoid being skinned by the game.

What is the appropriate length of an investment policy statement?

A long and wordy IPS doesn’t necessarily make it better. In fact, I have found the more complex an IPS becomes, the more difficult it becomes to execute, let alone enforce. Ultimately, the content and clarity of an IPS is more important than the length. I have yet to see a completed IPS at ETFguide that’s longer than six pages and anything longer would only be under special needs or investment circumstances.

Earlier this week I was asked by a podcast listener if a family trust will handle the job of an IPS and the answer is “no.” Remember: A trust is a legal document that describes how you want your assets to be distributed during and beyond your lifetime. On the other hand, an IPS covers the specific guidelines of how your assets are to be managed. In other words, your written IPS will complement your other important documents like your family trust and will.

Aside from describing what an investor’s goals are and how the goals will be achieved, another hallmark of a well-written IPS is that it protects the investor.  How is this done?

Providing a written guideline of what the acceptable maximum fee level for financial services the investor is willing to bear is another example of how the IPS templates designed by ETFguide are deliberately built to defend the investor’s interests vs. the investment manager. I have yet to see an investment policy statement produced elsewhere that puts a cap on investor fees. The main reason this occurs is because advisors don’t want a cap!

In summary, investing without an IPS is a big mistake. A well written IPS will protect you and keep your portfolio on track. Finally, make sure that your investment portfolio perfectly conforms to your written investment policy statement. Even the best crafted IPS is of little value if it’s not being followed.

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