A Three-Step Process For Developing An Investment Policy

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A Three-Step Process For Developing An Investment Policy

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Haphazard investment choices will rarely help you realize your goals, which is why every investor should take the time to develop a Statement of Investment Policy. Doing so provides you with a written summary of your investment objectives and the choices you’ve made to achieve them that can be revisited annually and modified as necessary.  Institutional investor advisors are typically required to construct Statements of Investment Policy for their clients, but retail investors can easily design their own by following an easy three-step process.

1. Define Your Investment Objectives

To begin, you need to list all of your investment objectives.  These should include both short-term and long-term targets.

For example, you may want to have $50,000 in five years for a down payment on a house, $100,000 to pay for your child’s college expenses 15 years down the road, and have enough to retire in 30 years with an annual retirement income of $50,000.  You also need to consider the amount of risk exposure you’re willing to accept to achieve these goals and determine whether your targets can be realistically achieved, given your risk preferences.  For example, if you currently have $10,000 saved, can save only $6,000 a year during the next five years, and are fairly risk-averse, you are simply not going to be able to have $50,000 accumulated in your account for a down payment on a house within 5 years.  To do so, you would have to invest in securities that offer an expected annual return of over 14%, and these will not be low-risk investments.

2.    Determine Your Asset Allocation

In this step, you decide on the classes of assets (i.e., U.S. stocks, U.S. corporate bonds, U.S government bonds, foreign stocks, foreign bonds, real estate, etc.) in which you will invest and the percentage of your money to be invested in each. Your asset allocation decision will be the primary determinant of the risk and return of your portfolio and, as such, needs to target your risk and return objectives, and, at the same time, factor in any investment constraints you may have. These constraints may include your investment time horizon, liquidity needs, tax considerations, regulations and restrictions, and unique personal needs or desires.

Investment time horizon:  All else equal, investors with longer time horizons can typically afford to take more risk since they will have more time to recover their losses if the market takes a downturn for a few years.  It is generally recommended that investors re-balance their portfolios to be more conservative as they get nearer to retirement.  The general rule of thumb is to subtract your age from 110 to determine what percentage of your funds to invest in stocks. For example, when you are 40 years old, 70% of your funds should be invested in stocks, while the remaining 30% should be in more conservative investments, like bonds; but when you are 60 years old, the recommended split is 50-50.

Liquidity needs:  In financial terminology, liquidity refers to the ability to convert your investments to cash with little or no loss in value.  Your savings account is a very liquid asset since you are able to withdraw the cash you’ve deposited in it along with any interest you’ve earned whenever you need to do so.   In contrast, your brand new BMW is not a liquid asset. Although you could probably sell it for $1,000 within minutes of putting it on the market, you would be taking a huge financial hit.

Some investors require more liquidity than others.  For example, an individual who has health issues or a retiree whose social security check is insufficient to cover his monthly expenses will have a greater need for liquidity than a person whose paycheck more than supports his present lifestyle.  Investors with larger liquidity needs must invest a higher percentage of their monies in liquid investments, such as savings accounts and money market mutual funds.

Tax considerations:  Every investor should take advantage of any tax-deferred retirement plans that may be available to him, such as the various IRAs plans and the Keogh, 401(k) and 403(b) plans.  But investors in higher tax brackets should also look to invest their non-retirement account money in securities that pay an income that is either tax-free or taxed at lower rates.  For example, municipal bonds, which are bonds that are issued by state and local governments, pay interest that is free from federal taxation and, in some cases, free from state and local taxation as well.  Non-dividend paying stocks provide their returns in the form of capital gains (i.e., price appreciation), which are not taxed until the stock is sold.

Restrictions and regulations:  Any restrictions on the invested funds must also be considered.  Money invested in a classic IRA or a 401(k) or 403(b) plan cannot be withdrawn without penalty until the investor has reached the age of 59 1/2, except under certain circumstances.  Therefore, an individual with some need for liquidity may not be able to direct all his investment dollars into a tax-deferred retirement account.  Too, regulations dictate the maximum amount of contributions that you can make to these types of accounts, regardless.  Variable annuities also have withdrawal restrictions that must be examined closely prior to investing.

Unique needs:  There is any number of unique needs that can be taken into consideration when selecting the types of assets in which to invest.  Some investors prefer not to support industries that they believe do not behave in a socially responsible manner.  Others may want to avoid investing in foreign securities, even if their risk tolerance level would support doing so.  Some may own rental properties and/or a vacation home in addition to a primary residence and may wish to avoid investing in any more real estate, thus ruling out an investment in a Real Estate Investment Trust (REIT).

3.    Select Specific Securities For Your Portfolio

Once you have decided on the classes of assets in which you will invest and how much you will invest in each, you will be ready to select the specific securities to include in your portfolio.  These can be individual stocks and bonds or portfolios of stocks and/or bonds, such as mutual funds and/or exchange-traded funds (ETFs), or some combination thereof.  You will then have a portfolio that is designed to meet your clearly defined goals and a written policy statement that you can review each year, making it easy to re-balance your portfolio as your circumstances change.

And they inevitably will.