6 Steps to Creating an Investment Policy Statement

One of the most important elements of a successful investment experience is the investment policy statement. This is essentially a written investment plan that allows you (and your advisor, if you have one) to have a written implementation, management, and review program for managing your investments. This is comparable to a business plan, without which very few businesses succeed. Writing an investment policy statement is a critical first step towards successful investing.

Institutional investors operate with investment policy statements as a standard matter of practice. It is a way for them to outline their investment processes and expectations, and effectively communicate these to their investment managers. It also provides a means for measuring results. Individual investors should be using investment policy statements for the same reasons, especially if they are working with a financial advisor.

An investment policy statement outlines an investor's circumstances including their objectives and constraints, risk tolerance, return objectives, time horizon, liquidity needs, funds available for investment, and the investment methodology to be followed. It is a written roadmap or set of guidelines to help you, your family members, and your advisor navigate through an uncertain future to achieve your investment objectives.

A written policy statement helps you maintain a disciplined investment approach even when market movements are distressing and your emotions may be causing you to second-guess your strategy. It also encourages effective communication with your advisor if you have one, or with other family members if you are investing on your own. A investment policy statement also creates a framework for reviewing important factors as they may change over time.

Here are the steps to creating an investment policy statement:

(1) Establish long-term goals and objectives - for most individual investors, long-term objectives include the need for supplemental retirement income, but can also involve large future expenditures such as the purchase of a vacation home, educational funding, or other long-term financial need. Retirement income planning should account for future inflation expectations and the need to generate sufficient income to maintain your quality of life throughout retirement.

(2) Define your investment time horizon - you may have several investment objectives, each with a different investment period. These should all be identified in your policy statement. Your time horizon is important because it will affect your asset allocation and risk profile and how your investments might change over time as you get closer needing money for various goals.

(3) Determine your risk profile - investment markets can be volatile and uncertain, so it is important to establish an acceptable and appropriate amount of risk for your situation. There are many different methods that can be used to evaluate risk. Most attempt to quantify the possibility that your expected returns or asset growth will be less than expectations. A skilled financial advisor can be of great help in this area.

(4) Establish an expected rate of return - in order to reach your financial objectives, your portfolio will need to appreciate at a certain rate. You will want to consider the required rate of return and work this into your investment plan. Of course, your portfolio's expected return is a direct result of its risk level. You should establish criteria for periodic review of your results compare to benchmarks and expectations.

(5) Develop asset allocation guidelines - having a written asset allocation policy will help guide your portfolio management decisions and assist your financial advisor in the ongoing management of your assets. Your portfolio's asset classes should have a low correlation with each other to provide diversification benefits. You should also consider the expected return and risk of each asset category as it relates to the portfolio as a whole. Other considerations include liquidity, tax efficiency, and rebalancing guidelines.

(6) Document an investment methodology - there are a variety of investment strategies you can follow to implement an investment program. Be sure to carefully evaluate the pros and cons of different approaches and memorialize your personal preferences in your policy statement. This will help guide you and your advisor as market conditions change and as you might consider new investment vehicles and strategies in the future.