In a previous post, we discussed the importance of implementing and sticking to an investment plan. Before deciding how to invest your assets, it is important to work with an advisor to create an investment policy statement (IPS). An IPS acts as a road map, defining your general investment goals by looking at your risk and return objectives as well as investment constraints. Creating an IPS will guide you on which investments and strategies will best fit your unique situation.
Objectives
- Return Requirements explain your long-term return goals. Are you looking for growth, income, capital preservation, or a mixture? These goals should be reasonable and consistent with your risk tolerance.
- Risk Tolerance is broken into two sections: ability and willingness. Ability to take risk refers to your portfolio’s capacity to take risk. The ability is affected by factors such as time horizon, liquidity needs, etc. If you need to take a large withdrawal within the next year, you would have a lower ability to take on risk than if you don’t need your money for 10+ years. Willingness to take on risk is a psychological measure. This refers to your comfort level with taking risk, including how you can handle the fluctuations within your portfolio. When working with a financial advisor, they will provide you with a Risk Tolerance Questionnaire, designed to reveal your willingness for risk. One simple measure is to ask yourself, if my portfolio drops X% would I still be able to sleep at night? If you’re not willing to endure a potential large loss of X% , your willingness to take risk is lower.
Constraints
- Time Horizon is how long you expect to hold your investments before you start withdrawing money to spend. This can be categorized as short-term, intermediate-term, or long-term. Your time horizon is directly correlated with your ability to take risk. If you have a short time horizon, your ability to take risk is low because you will require distributions soon. The sooner you require distributions, the less time your portfolio has to recover from a loss, so risk is reduced. For example, someone who is nearing retirement does not have the time to make up for a potentially large loss. If they are allocated too aggressively and incur a large loss within their retirement account, this could affect their retirement date. A longer time horizon gives you the ability to take on more risk as you do not require distributions anytime soon, so your portfolio can withstand more fluctuations to achieve higher potential returns.
- Liquidity Needs refer to the amount of money you need from your portfolio in the short term. This is inversely related to your ability to take risk. The higher your need is for liquidity, the lower your ability to take on risk. Liquidity needs can refer to one time expenses as well as ongoing portfolio withdrawal requirements. One time expenses include costs such as paying off a mortgage, paying for your daughters wedding, paying for college, etc. Ongoing withdrawal requirements are based on your annual needs such as living expenses above your income (ex: you need to take 5% per year from your portfolio for living expenses).
- Tax Implications should dictate how you invest your portfolio. It is important to create a portfolio based on after-tax returns. If you are in a high tax bracket, your portfolio might look different than if you had to pay less, or no taxes. This is more important for non-qualified accounts because IRA’s, Roth IRA’s, 401(k)’s, etc are tax deferred or tax free. To simplify this concept, let’s do some fun math. Assume you pay 30% average taxes and have the option to invest in either a tax free municipal bond fund or another fund that makes you pay taxes each year. If the municipal bond fund has an average return of 5%, you would need to achieve a return of 7.14% in the other taxable fund just to break even (5% / [1-.30] = 7.14%). So if the taxable fund averages 6%, even though this is higher than the 5% initially, you would be worse off after the tax consequences. This is an extremely simplified example, but you get the point.
- Regulatory Constraints refer to the environment that is specific to your portfolio. This traditionally has a lower impact on individual investors as most regulatory constraints apply to larger institutions. Just be sure to understand the laws and regulations of the economies where your money is invested.
- Unique Circumstances are any additional special requirements you have not covered in the other constraints. A common example of this is socially responsible investing. This is investing that is considered socially responsible due to the nature of the business the company conducts. This could exclude companies in certain industries such as tobacco, gambling, etc. Other unique circumstances include a lack of diversification due to an ESOP, ownership of a private company, and personal health concerns. Make sure to take the time and think of any unique circumstances specific to you.
Understandably, creating an IPS is a crucial step in constructing a suitable investment portfolio tailored to your unique needs and desires. It’s important to go through this process as it will take the complexity out of selecting from the endless investment options available. This will leave you with a distinct direction prior to making any investment decisions.
Ben Webster, CFP® and Derek Prusa, CFA, CFP®
Co-Founders and Owners of Aspire Wealth
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