There is much said about the need for a clear financial plan to maximize savings for retirement, college and other goals. But before you create that plan, you'll want guidelines to help you write it.
It's like this: If your plan is a road map, you need to know where you want to go first, right?
In the financial community, that expression of goals is called an investment policy statement. These statements have long been used by big institutional investors like pension funds and charities.
Brokers and financial advisers who serve individual investors are increasingly depending upon investment policy statements to lock in their clients' goals and intentions. Some of that comes from the time-honored tradition of butt-covering: Brokers who are legally required to recommend 'suitable' investments for their clients must know enough about them to do that. They can use the statements to round out the picture of their clients.
It's the client's opportunity to tell the adviser: 'This is my philosophy, and this is how I want my portfolio managed within that philosophy', says Nancy Lininger, a compliance consultant to the brokerage industry. It also affords an opportunity for you to lay out the criteria by which you will evaluate your adviser's performance going forward.
If you're working with an adviser, there is a good chance that she or he will walk you through the development of a policy statement, so make sure it reflects the way you really feel about your investments. If you are a DIY investor, you should write your own statement so you can then map your strategy properly.
The important thing to remember is that, regardless of whether you plan or not, you are following an investment strategy, Thomas Collimore, director of investor education for the CFA Institute, wrote recently in a paper on investment policy statements. The benefit of having a coherent document that outlines an investment plan is clear: It's easiest to evaluate your manner of investing if you spell it out.
So write one. Here are some of the items that should go into your own personal investment policy statement. For more guidance you can check out Morningstar's fill-in-the-blanks investment policy worksheet here (here).
-- What (and when) are you saving for? Be specific: You would like to fund a 30-year retirement starting in 15 years; you'd like to send your 7-year-old to a good private college in 11 years; you want enough money to buy a second home, start a family charity, take a special trip for your anniversary in five years.
-- What is your investment philosophy? Do you have any ethical guidelines you'd like your investment choices to reflect?
-- What's your risk tolerance? This is a tough one, because most people don't even really know what their risk tolerance is until they confront a loss they can't handle. Try to be realistic about how you would feel if your entire portfolio fell 10 percent, 20 percent or 40 percent; or, if any one investment lost even more than that, or disappeared altogether. Know that if you have no tolerance for loss, you will miss out on the best returns of stocks and bonds. But if you're going to panic and sell all in the middle of a decline, you should know that before you start buying all in the middle of a bull market.
-- What's your investment philosophy? Do you believe in buying inexpensive index funds and trading infrequently? Prefer individual stocks? Like winning fund managers?
-- What's your tax situation? Are you investing money that is mostly in a tax-deferred or tax-free account? If not, what's your tax bracket? How much of a priority will you put on reducing taxes on your investment income?
-- How much information do you want? Do you want to update your portfolio daily or hourly, or will a quarterly report be enough for you? How responsive would you like your adviser to be to your phone calls?
-- How will you monitor your performance and your adviser? That's not a simple question. Will you compare your investments to similar indexes, or pass judgment on your adviser by your progress against your key goals? Or both? Name your benchmarks.
-- What's your target asset allocation? How often do you want to see your portfolio rebalanced so it fits that allocation? Many experts suggest laying this all out in the investment policy statement, but it seems as though this could come later, as part of the plan. And you may not want to get too specific. As Lininger says: The more you limit advisers and tie their hands, the less they are able to react proactively to changes in the market. On the other hand, she concedes, you don't want your adviser running wild, either. A good investment policy statement will give that adviser just the right amount of room to move.
(The Personal Finance column appears weekly. Linda Stern can be reached at linda.stern(at)thomsonreuters.com)
(Editing by Gunna Dickson)